Excerpted from The Real Interest Rate Conundrum

By
Henry C.K. Liu http://www.henryckliu.com/page135.html 20070612

Volcker’s Blood-letting Experiment

The “new operating procedure" was adopted on October 6, 1979 by the Fed under Paul Volcker as a therapeutic shock-treatment for Wall Street, which had been conditioned by former Fed Chairman Arthur Burns’ brazen political opportunism during the Nixon era in the 1970s to lose faith in the Fed’s political will to control inflation. The new operating procedure, by concentrating on monetary aggregates, and letting it dictate FFR [Fed Funds Rate] swings within a range from 13-19%, to be authorized by the Fed Open Market Committee (FOMC), was an exercise in “creative uncertainty” to shock the financial market out of its complacency about the Fed’s traditional policy of interest-rate stability and gradualism.

There had been a traditional expectation in the market that even if the Fed were to raise rates it would do so gradually so as to not permit the market to be volatile. The banks could continue to lend as long as they could profitably manage the gradual rise in rates. Under the new operating procedure, the banks would be exposed to risks that interest rates might suddenly and drastically go against even their short-term credit positions. Also, banks had been seeking higher earnings by expanding new loans beyond the growth of deposits, by borrowing shorter term funds at lower interest rates. This practice was given the benign name of “managed liability” by regulators, allowing banks to profit from interest-rate spreads over the yield curve, which had seldom if ever been allowed by the Fed to stay inverted, that is with short-term rates higher than longer-term rates, at least for long. This practice of interest rate arbitrage later came to be known as “carry trade” in bank parlance [So this is NOT inherent to fractional-reserve banking. It is something that began under easy Arthur [Burns].], and when internationalized, eventually led to the Asian financial crisis of 1997 when interest-rate and exchange-rate volatility became the new paradigm that could roil equity and currency markets.

The Fed’s new operating procedure would greatly increase the banks’ risk exposure, at least before the widespread practice of loan securitization shifting individual bank risk to systemic risk for the entire financial market. On top of it all, Volcker also set an additional 8% reserve on bank borrowed funds for lending. The new operating procedure violated the traditional mandate of the Fed, which, as a central bank, was supposed to be responsible for maintaining orderly markets, which meant smooth, gradual changes in interest rates which in turn would keep money supply fluctuation moderate and gradual so that prices would not be detached excessively from market fundamentals. The new operating procedure was a policy to induce the threat of severe short-term pain to stabilize long-term inflation expectations.

Most economists agree that when money growth slows, market interest rates go up. The trouble with the use of the FFR target to control money supply is that it has to be set by fiat, which exposed the Fed to political pressure to keep a liquidity boom going forever. A case can be made, and is frequently made, that the Fed’s FFR targets tend to be self-fulfilling prophecies rather than a device to manage future trends. High FFR targets deflate while low targets inflate, and there is little argument about that relationship, at least before the age of structured finance when virtual money can be created within the system circularly outside of the Fed’s control. Under structured finance, high FFR targets can actually inflate because they raise the cost of money needed for protection through hedging and for profiteering through financial arbitrage.

But there is plenty of argument about the Fed’s projection ability on the economy. History has shown that the Fed, more often than not, has made wrong decisions based on faulty projection that at times borders on blind denial of clear data. The new operating procedure would let the monetary aggregates set the FFR targets scientifically and provide political cover for the Fed Open Market Committee (FOMC) members if the FFR target needs to go to double digits. This amounts to monetarism through the back door, not by heroic intellectual confidence in scientific truth, but by political cowardice.

The Federal Advisory Council (FAC) of the Federal Reserve Board is unique in that it is a big-bank lobby composed of twelve representatives of the banking industry that officially advises the Fed, itself a peculiar institution: an all powerful public institution mandated by law, but owned by private banks. The FAC meets in secrecy four times a year with Fed officials to give the banking industry an inside track on influencing Fed deliberation, if not decisions. The since-declassified minutes of the FAC show that four weeks before the Volcker Fed announced its “new” operating procedure on October 6, 1979, the FAC had recommended to the Fed a review of its “traditional” operating procedure, before even the President was alerted of the Fed’s deliberation and final decision to adopt a “new” operating procedure. Initially, the FAC was concerned that political pressure was likely to push FFR down, not anticipating that money supply would turn volatile to create extreme interest rate volatility.  Carter, preoccupied with the Iran hostage crisis, was totally in the dark about the impending volatile high-interest-rate policy with which the Fed under Volcker, a Republican, was going to hit Carter’s Democrat administration running for a second term within a year.

To stabilize money supply, the Fed announced on March 14, 1980 a program of Emergency Credit Controls. The program affected not only commercial banks, but also money-market mutual funds and retail companies that issue credit cards. Banks would be limited to a 9% credit growth instead of the 17% in February. By April, the Fed was shocked by data showing money disappearing from the financial system at an alarmingly rapid rate. The last two weeks in March saw more than $17 billion vanish, representing an annualized shrinkage of 17%, yielding a 34% change. Money was evaporating from the banking system as credit dried up and borrowers paying off their debts in response to Carter’s moralistic jawboning to save the nation from hyper-inflation through personal restraint on consumption. Another cause was the shift from bank deposits to three-month T-bills that were paying 15%, causing money to exit the market back into the Fed’s vault.

Volcker’s new operating procedure adopted six months earlier now faced a critical test. According to monetarist theory, the Fed now must pump up new bank reserves to stop the money supply shrinkage. But in practice, Volcker and the FOMC were applying 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, destabilized the economy unnecessarily. When mortals play god, other mortals die unnecessarily.

On May 6, 1980, with the New York Fed’s Open Market Desk furiously trying to reverse a raging money-supply shrinkage, pumping in money to the system by buying government securities and depositing the funds in banks to create new additional “high power” money by increasing bank reserves for lending, interest rates fell sharply and abruptly. The FFR dropped 500 basis points in two weeks, from 18 to 13%, the bottom of the FOMC range in the new operating procedure, and was actually trading below the low FOMC target range at one point.

Telling the Monetary Train to go in Opposite Directions Simultaneously

The Fed was in danger of losing control of its FFR target to the market and jeopardizing it own credibility. The New York Fed notified the FOMC that it could continue to follow the new operating procedure by injecting more bank reserves to let the FFR fall below the low limit set by the FMOC or to tighten up the supply of bank reserves to get the FFR back up to the 13% set by it, but it could not do both, any more than a train could go in opposite directions simultaneously.

Volcker opted for continuing the new operating procedure and staged an emergency telephone conference of the FOMC to authorize a new low FFR target of 10.5%, down from 13%, way below the inflation rate of over 12%.

Market conditions were such that interest rate falling below 10% would mean below-neutral negative interest rate after inflation adjustment, which would start another borrowing binge to exacerbate further inflation. The fundamental fault of monetarism was being exposed by real life. The claim that stabilizing the money supply would also stabilize interest rates was shown to be inoperative by events. In reality, attempts to stabilize the money supply actually destabilized interest rates and pushed them down in a fast-reacting dynamic market in an environment of shrinking liquidity.

Desperate, the Fed under Volcker, with concurrence from an even more panic-stricken Carter White House, started to dismantle Emergency Credit Controls as fast as administratively doable, so that demand for credit would not be artificially shut down, in hope of making market interest rates rise from more borrowing. Still it took until July 1980 before the last of the credit controls were lifted. Back in April, the New York Fed had injected additional reserves into the banking system at an annualized rate of 14% and in May at 48% annualized rate in non-borrowed reserves, pushing interest rates down and lay the ground for future inflation.

It was obvious Volcker panicked, spooked by the sudden economic collapse set off by his own credit-control program to slow the rise in money supply. By the last week of July, the FFR fell below the 13% discount rate and hit 8.5% down from 20% in late March. 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 down on its own, unhinged from FFR target. With the FFR below the discount rate, the FFR could fall to zero by banks responding to market forces. So the pressure to lower the discount rate was overwhelming. The financial markets had never seen anything like it. The money market became a game in which the guards had thrown in the towel and the inmates were running the asylum.

Correcting one Overshoot with another Overshoot

The FFR dropped from 20% in April to 8.5% in 10 weeks, effectively banishing interest rate gradualism out to the wilderness. In the autumn of 1979, the Fed had seized the initiative to push the price of money up 100% to fight inflation. Now, barely seven months later, the Fed allowed the price of money to fall even more rapidly to reverse the money-supply shrinkage, with “damn the inflation torpedo - full speed ahead in the sea of liquidity” frenzy. The recession abruptly ended by the Fed’s overreaction and Volcker, the self-ordained slayer of the inflation dragon, became overnight a breeder of baby dragons of even more aggressive inflationary DNA and the economy was facing a worse, and more interest-rate immune inflation problem than when he first became Fed chairman in July 1979 less than a year ago.

Many businesses that were profitable under a steady interest rate regime went bankrupt during this brief period of sudden Fed-manufactured volatility in liquidity, but the banks were dancing in the street with windfall profits and excess cash to lend.  Volcker’s “new operating procedure” experiment put the Fed back on its traditional path: focusing on interest rates and not money-supply numbers and vowing again to focus only 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 and the world pay a very costly tuition.

Volcker’s high interest rate policy caused the dollar to rise in the foreign exchange market, making US exports less competitive, but US investment overseas less expensive. The rise in import prices was moderated by lower profit margins made affordable to foreign importers whose dollar earning now was worth more in local currencies.

Instead of restructuring the US economy and to reform the terms of globalized trade to address a mounting structural US trade deficit, Treasury Secretary James Baker under President Reagan took the easy way out and engineered the Plaza Accord on September 22, 1985 to push the dollar down by coordinated intervention by the central banks of US, Japan and Germany, France and Britain. Two weeks earlier, on September 6, the Fed had raised the Fed Funds Rate target 25 basis points to 8% from 7.75% set mid-July, putting upward pressure on the dollar as the Treasury was trying to push the dollar down.

The Plaza Accord when finally put in place pushed the Japanese yen down by over 50% against the dollar with central bank intervention. But it had little discernable effect on the US trade deficit. It did allow the US to export deflation to Japan to use the dollar’s low exchange rate to boost up US asset value nominally. The Plaza Accord decoupled dollar interest rates from the exchange value of the dollar and also decoupled the traditional link between rising interest rates and falling equity prices.

Time Magazine reported on January 26, 1987 that John Makin, director of fiscal-policy studies at Washington’s American Enterprise Institute, argued that the value of the dollar was “totally irrelevant. If the budget deficit isn’t going to improve very much, the trade deficit isn’t either.” Sidney Jones, an economist at the Brookings Institution, also warned of a danger if the dollar’s exchange rate continued to serve as the main instrument for altering the trade balance: the risk that the US inflation rate, about 2% in 1986, would flare up. “Once those import prices do go up, then you can get away with increasing domestic prices. That's probably a greater inflation risk than simply the increase in the price of imported goods,” Jones was quoted as saying. Yet the House passed a highly restrictive omnibus trade bill, but it stalled in the pro-trade Republican-controlled Senate.