Still More on the Fed

["ÁÎ×Ó¹â Henry C.K.Liu ¹ù¤l¥ú" <hliu@xxxxxxxxxxxxxx>]

The core of the Federal Reserve's political base is the commercial banks.
As more banks resigned from the Federal Reserve System, the System ran the
risk of being exposed to political attack.  The Fed's control of monetary
policy technically requires membership of no more than the four hundred
largest banks.  Universal membership brought in thousands of small
regional and local banks that were crucial for the Fed's political
protection.  Since its beginning in 1913, the Fed has been subjected to
criticism that it is a captive institution of the big banks.

To gain support for the Monetary Control Act of 1980, the Fed offered
member and non-member banks that, under universal membership, the existing
levels of reserves would be lowered for every bank.  Reserves required for
demand deposits, the checking accounts that represented the core of bank
funds, were reduced from 16.25 to 12%.  This would mean a substantial loss
of revenue for the Fed.  The Fed had been paying handsome dividend to the
Treasury from surplus income from reserves holding invested in government
securities over operating expenses ($9.3 billion in 1979).  The Fed
started to charge banks for its services when the new reserves rules were
fully phased in.  The larger money center banks welcomed this development
since they intended to provide their own service system for banks in
competition with the Fed, and with the Fed charging a fee, it would make
it easier for the big banks to lure away customers.  To get the
endorsement of the ABA, the Fed agreed to drop reserves requirement on
time and saving deposits.  This concession meant a vast benefit for the
big banks whose balance sheet depends on large denomination CDs.

Volcker, as Chairman,  adopted a "new operating method" for the Fed as a
therapeutic thunderbolt on Wall Street which seemed to have lost faith in
the Fed's political will to control inflation.  The new operating method,
by concentrating on monetary aggregates, and letting it dictate rates
swings within a range from 13 to 19%, to be authorized by the FOMC, was an
exercise in "creative uncertainty" to disrupt the financial markets'
complacency about interest rate stability.  There had been a traditional
expectation that even if the Fed were to raise rates, it would not permit
the market to be volatile.  The banks could continue to lend as long as it
could profitably manage the gradual rise in rates. Under the new operating
method,  the banks had to take risks that interest rates might suddenly
and drastically go against them.  Also, banks had been expanding new loans
beyond the growth of deposits, by borrowing short term funds at lower
interest. This practice was given the benign name of "managed liability",
allowing banks to profit from interest rate spreads.  This practice, known
as "carry trade", eventually led the the Asian financial crises of 1997,
but I shall deal with that and the Fed's role in it later.

The Fed new operating method would greatly increase the banks risks.  On
top of it all, Volcker also set an additional 8% reserve on borrowed funds
for lending.  The new operating method worked against the traditional
mandate of the Fed which, as a central bank, was supposed to be
responsible for maintaining orderly markets, which meant smooth changes in
interest rates.  The new operating method was a policy to induce short
term pain to stabilize long term inflation expectations.

Every economist agrees that when money growth slows, interest rates go up.
  The trouble with the use of the Fed Funds target to control money supply
was that it had to be set by fiat which exposes the Fed to political
pressure.  The new operating method would let the monetary aggregates set
the Fed Funds rate and provided political cover for the FOMC members if
the Fed Fund needed to go to double digits.  This was monetarism through
the backdoor, not by intellectual commitment, but by political cowardice.

The Federal Advisory Council (FAC) of the Fed is unique in that it is a
big bank industry lobby that officially advises the Fed.  It meets in
secrecy four times a year with Fed officials.  Four weeks before the Fed
announced its new operating method, the minutes of the FAC showed that the
Council had recommended to the Fed a review of its tradition operating
method, before the President was alerted of the Fed's deliberation and
final decision.

The Fed announced on March 14 a program of Emergency Credit Controls not
only on commercial banks, but also on money market mutual funds and retail
companies that issue credit cards. Banks would be limited to 9% credit
growth instead of the 17% in February.  By April 1980, the Fed was shocked
by data that money was disappearing from the financial system at an
alarmingly rapid rate.  The last two weeks in March saw more than $17
billion vanished, representing an annualized shrinkage of 17%.  Money was
evaporating from the banking system as credit dried up and borrowers were
paying off their debts at President Carter's urging: to save the nation
from hyper inflation through personal sacrifice on consumption.  Another
cause was the shift of bank deposits to three month T-bills which were
paying 15%.

Volcker's new operating method adopted 6 month earlier was facing a severe
test.  According to monetarism, the Fed now must pump up bank reserves to
stimulate money growth.  But in practice, Volcker and the FOMC was to
apply monetarism, which by definition must be a long-term proposition, to
short term turbulence, and in the process, undermined their own earlier
efforts to fight hyper inflation and worse, to destabilize the economy
unnecessarily.

On May 6, with the NY Fed's Open Market Desk furiously trying to brake the
money supply shrinkage now in full progress, pumping more bank reserves by
buying government securities and creating new money, interest rates fell
abruptly.  The FFR dropped 500 basis points in two week, from 18 to 13%,
the bottom of the FOMC range and was actually trading below FOMC target.
The Fed was in danger of losing control of its interest target.  The NY
Fed notified the FOMC that it could continued to follow the new operating
method by injecting more reserves or to tighten up the supply of banks
reserves to get the FF rate back up to 13%, but it could not do both.
Volcker opted for continuing the new operating method and staged a
telephone conference of the FOMC to authorize a new Fed Funds rate of
10.5%.

Market condition was such that interest rate falling below 10% would mean
negative interest adjusted for inflation which would restart another
borrowing binge.  The fundamental fault of monetarism was being exposed by
real life. The claim that stabilizing the money supply will also stabilize
interest rate was inoperative.  In reality, stabilizing one destabilized
the other.

Desperate, the Fed, with concurrence from an even more panic stricken
Carter White House, started to dismantle the Emergency Credit Controls as
fast as administratively possible, so that demand for credit would not be
artificially dampened, in hope of making interest rate rise from more
borrowing.  Still it took until July 1980 before the last of the controls
were lifted.  In April, the NY Fed added reserves at an annualized rate of
14%, and in May at 48% annualized rate in non-borrowed reserves.  It was
obvious Volcker panicked by the sudden economic collapse touched off  by
his own credit control program.  But the last week of July, the Fed Funds
rate fell below the discount rate and hit 8.5%.  For one trading day, it
dipped to 7.5% and for a time the Fed lost control. The short term rate
that monetary policy regulates most directly was free floating on its own.
  With the Fed Funds rate below the discount rate, the FFR could fall to
zero.  So the pressure to lower the discount rate was overwhelming.  The
financial markets had never seen anything like it.  The FFR dropped from
20% in April to 8.5% in ten weeks.  In the Autumn of 1979, the Fed had
seized the initiative to push the price of money up 100% to fight
inflation.  Now the Fed allowed the price of money to fall even more
rapidly to reverse a money supply shrinkage.  The recession abruptly ended
by the Fed's over reaction and Volcker was facing a worse inflation
problem that when he first became Chairman.

The experience put the Fed back on its old path: focusing on interest
rates and not money supply numbers and to vow again to focus on the long
term.  Yet, for the long term, money supply was the correct barometer,
while for the short term, interest rate was the appropriate tool.  The Fed
did not seem to have learned anything, despite having made the nation pay
a very costly tuition.

To make the case that money supply, rather than interest rates, move the
economy, one would have to assert that the money supply affected the
economy with zero lag.  Such a claim can only be validated from the long
term perspective.  For the long term, six months may appear as zero, just
like macro economists may consider the bankruptcy of a few hundred
companies creative destruction, until they find out some of their
relatives own some of the bankrupt companies.  Targeting the money supply
produces large sudden swings in interest rates which produce unintended
shifts in the real economy which then feed back into demand for money.
The process has been described as the Fed acting as a monetarist dog
chasing its own tail.

By September 1980, data on August money supply revealed that it had grown
by 23%.  Monetarists, back by the banks, clamored for interest rates hikes
dictated by money supply data.  Having been burnt a few months earlier,
the Fed was not going to abandon its interest rate gradualism focus and
let the money supply tail wag the interest rate dog.  Still, the Fed
raised the discount rate from 10 to 11% on September 25, still way behind
both monetary aggregates needs and inflation rate.

Carter attacked the Fed for its high interest rate policy in the final
weeks of his campaign.  Reagan defended the Fed's unfair scapgoating by
Carter.  After the election, the Fed continued its high interest rate
policy while the Reganites were preoccupied with transition matters.  By
Christmas, prime rate for some banks reached 21.5%.

The economic disorder that elected Reagan followed him into office. Carter
blamed inflation on prodigal popular demand and promised government action
to halt hyper inflation.  Reagan reversed the blame and put it on the
government.  Yet Reagan's economic agenda of tax cuts, defense spending
and economic growth was in conflict with the Fed's anti inflation tight
money policy.  The monetarists in the Reagan administration were all
longtime critics of the Fed. Yet the unrealistic fiscal policies of the
Reagan administration (balanced budget despite massive tax cuts and
increased defense spending) overshadowed its fundamental monetary policy
inconsistency. Economic growth with shrinking money supply is simply not
consistent, monetarism or no monetarism.

The Reagan presidency marked the rehabilitation of classical economic
doctrines that had been in eclipse for half a century.  Economics students
since WWII had been taught classical economics as a historical relic, like
creationism.  They viewed its theories as negative examples of
intellectual underdevelopment.  Three strands of classical economics
theory were evident in the Reagan program: monetarism, supply side theory,
and phobia against deficit financing.  Yet these three strands are
mutually contradictory if pursued equally with vigor, what Volcker gently
warned in his esoteric speeches as a "collision of purposes".  Supply side
tax cuts and economic growth conflict with monetarist money supply
deceleration, while military spending with tax cuts means deficits.
Voodoo economics was in full swing.

Volcker began to gain control over the White House through his rationality
and adherence to reality which allowed him to dominate events over the
White House's doctrinaire "rational expectation": the theory that rational
market participants always anticipate government policy and adjust their
actions accordingly.

By March 1981, Fed Funds rate, which reached historic 20% in January, had
been pushed to below 16% by the FOMC.  The bond market refused to go
along.  Long-term rate went up.  Henry Kaufman blamed it squarely on the
Reagan expansionary tax cuts.  M-1 started to expand rapidly in April.
Bond traders feared a Fed tightening with interest rate hikes, thus
depressing the bond already held at lower rates.  Traders began bidding up
rates in anticipation.  Rational expectation was working against the
Reagan economic plan, instead of with it.  The Fed pleaded with market
specialists not to jump to extreme conclusions based on a two week change
in the supply of money, that the Fed was no longer using the new operating
method.  But the bond market reacted nervously to M-1 data and the Fed
reacted nervously to the bond market.  Monetarism was made real not by
logic but by market sentiment.

For interested amateurs like myself, reading the daily "Credit Markets" in
the WSJ was like crashing in on the private club of bond traders,
eavesdropping on a no nonsense summary of Fed watcher analysis.  Fed
economists also read the column religiously like Broadway stars read
opening night reviews.  It is their main source of information on market
sentiment.  To participate in this media dialogue, one has to accept
certain basic assumption, lest the material should sound illogical and
incomprehensible.  The assumptions are: the Fed first priority is to
maintain interest stability, orderly markets and "hard money", above
economic growth or full employment or any such socialist claptrap.

When bond prices fell in April 1981, the Fed discreetly yielded to the
judgment of the bond market. Though economic recovery was no where in
sight, the Fed again changed direction in its interest rate policy and
moved rates upward.  The Fed was forced to follow the market instead of
leading it.  As the Reagan program moved through Congress, gathering
popular enthusiasm and legislative momentum, the bond market went into
seizure.  The Fed was faced with the option of losing control of the FFR
or cutting more drastically the money supply and push up interest rates.
Long term high grade corporate and government bonds were seeing their
market rates jump 100 basis points in one month.  New issues had
difficulty selling at any price.  The possibiltu of a "Double Dip"
recession was bantered about.  The Fed was attacked from all sides,
including the commercial banks which held substantial bond portfolios, and
White House supply siders, despite the fact that everyone knew the trouble
originated with the Reagan economic program.  The Democrats were attacking
the Fed for raising interest rates which was at least conceptually
consistent.

The White House accused the Fed of targeting interest rate again instead
of focusing on controlling  monetary aggregates. Volcker was accused of
undermining the President.  Reagan publicly discussed "abolishing" the
Fed.  In mid April, Volcker had publicly committed himself to gradualism
in reining in the money supply and avoid shock therapy, to give the
economy time to adjust.  But his changed his promise by May, and decided
to tighten on an economy already weakened by high rates imposed six months
earlier, yielding to the White House and the bond market.  Gradualism was
permanently discarded.  Volcker's justification was amazing.  He told a
group of Wall Street finance experts in a two day invited seminar that
since policy mistake in the pst had been on the side of excessive ease, in
the future, it made sense to err on the side of restraint.  Feast and
famine was now not only a policy but a policy rationale as well.

Next, the Fed's policy of foreign exchange value of the dollar and its
role of the Third World debt mess.

Henry C.K. Liu