Re: James A. Baker III

["Henry C.K. Liu" <hliu@xxxxxxxxxxxxxx>]

Hello Warren,

Volcker, as Fed 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.

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, 1980 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 was 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.

You are correct Warren that the NY Fed open market desk, driven by
market forces, could not follow the auhorized target of the FOMC, and
for a brief period, the Fed actually lost control to the market, until
it lifted credit control.

Henry

Warren Mosler wrote:

> > Volcker listened politely but held on to his belief
> > that the technical decision was the Fed's "independent"
> > prerogative. The new operating system caused the Fed to lose
> > control of interest rates and cost Carter another term.
>
> Henry,
>
> As a technical matter I would say defacto control of the overnight
> interest rate
> was shifted from the DC to the NY Fed for that period.
>
> w