The Fed Will Do What It Does, and It Won't Matter
AP Photo/Charles Dharapak, File
The Fed Will Do What It Does, and It Won't Matter
AP Photo/Charles Dharapak, File
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Interest rates were skyrocketing, a real sell-off. Bond yields way up, money markets, too. There was intense pressure from seemingly everywhere, including out in the federal funds market. To at least try to do something about that last one, the suits at the Federal Reserve dialed up some huge reverse repos.

Sure seems tiny by comparison to today’s multi-trillions, but $3.7 billion overnight on reverse repo was, at the time, truly massive. It had to be, otherwise policymakers would have been confronted with a malcontent rate. The situation was already ridiculous to begin with, but now there would be a shortage of reserves on top of out-of-control inflation.

This was October 1979, the 22nd to be exact. Federal Reserve Chairman Paul Volcker, only a few months into his tenure, had called an emergency conference call of the entire FOMC and all its massive staff. The purpose was to address the condition in federal funds.

On that same day, the effective federal funds rate (there was no policy target back in those days) skyrocketed to 17.60%. This was up from 15.07% the day before, the 21st, and 11.61% as late as October 8.

For policymakers, this was their policy at the time, the very one which would (later) make Paul Volcker famous. To finally put the clamps on the Great Inflation, the new Fed Chair would starve the system of money. That’s the myth.

Since inflation is money, paging Friedman, theoretically this only made sense. In practice, always more complicated. Before the month of October 1979, the policy was put in place and slowly, at first, the federal funds rate (effective) began to rise until, suddenly, the shortfall caused the Fed to blink.

Thus, by October 22, and in the days leading up to it, the Fed’s operational arm, the Open Market Desk, had uncorked some billion-plus RPs (as they were designated) to “supply reserves” into what was now being treated as an oversight. At 9:45am that day, the Desk had underwritten a whopping $3.7 billion.

The FOMC call took place later to put its stamp on the operation(s) while simultaneously seeking counsel from among its members whether to continue them, how to continue them, set what limits on these interventions, etc.

At that particular moment, Volcker like the rest didn’t want to attach a specific federal funds target (this would come later, in a fair bit of revising history) to the RPs; as in, a potentially unlimited quantity of RP to achieve a predetermined federal funds effective. The majority opinion was just to get the rate to come down from its uncomfortable perch by supplying more reserves via RPs even though the FOMC had previously committed to making them scarce through other policy means.

At this early stage, already not quite the same as what’s mythologized. More than a tinge of regret, this was all seen as a sort of fine-tuning to a tightening monetary policy gone a step, maybe, too far.

Or was it?

Insofar as reserves were counted, these certainly had become scarce. Since they are borrowed, lent, and relent in the federal funds market you can understand the suddenly towering behavior behind the federal funds rate. Real money, though, that remained a different story.

Before getting to the federal funds fiasco, Staff Director and Economist Stephen Axilrod relayed the gory details for the telephonically assembled members this October; money rather than reserves. The FOMC had previously set monetary targets for M1 and M2 at 4.5% and 7.5%, respectively, each annual rates of expansion during the quarter in question (Q4 ’79).

“MR. AXILROD. Based on data thus far in October--that is, data through October 17, with the last week being preliminary-M1 looks as if it's on a path where its growth in October will be at an annual rate of about 14.3 percent and M2 looks as if it's growing at an annual rate of 13.6 percent.”

 While those numbers were to some degree seasonal, the FOMC would find that, over time, M2 tended to bounce all around following peak expansion registered back in ’77. In other words, M2 really wasn’t the problem here and it didn’t seem to matter whether reserves were ample or indiscriminately tight.

Volcker had made reserves scarce straight away, as was the intent, but the money aggregates were largely uncorrelated. It would continue to be for M2 throughout the next several years, zipping around either near the Fed’s target range or several points above.

It was as if something else held a hold on consumer prices, like money, an unrelenting if unseen force unwilling to let them go. The untested Volcker had provoked a “reserve” reaction rather than a monetary one, which, with some RPs, quickly died down and already he’s contradicting the notion of some determined inflation-fighter.

The inflation did not die down, at least not until something else drilled the economy – and not just in the US.

Nearly a month after that conference call, the FOMC convened on its regular schedule for November 20, 1979. Much was made about money, and then shortly the other thing. First, coming closer to the end of the meeting, Governor Henry Wallich plainly stated all their own shortcomings:

“MR. WALLICH. I don't think M1 measures what it is supposed to be measuring. If we had the revised aggregates—and revised them the way I would like to see them revised--that [new] M1 would be advancing faster. We see bank credit advancing fast, and it has grown at a very stable rate all through the year, fluctuating in an 11 to 14 percent range. And in the forecast it is not projected to slow down; it's currently projected to increase at its [recent] rate of growth month by month through January [1980].”

Perplexed, policymakers couldn’t find the magic way to slow down money and credit, even after finally starting to account for that huge blind spot over how the M’s - M1, M2, and M3 - were each outdated long before all this. The simple truth of the matter was no matter what the Fed did, including restricting reserves to the extent of what had transpired during October 1979, banks appeared to be wholly undeterred.

In fact, that banks were unstoppable had been the cause of the reserve crisis, if you’d call it that, in the first place. Creating deposits and loans at these rates meant the need for reserves not as loanable money but to satisfy certain regulatory issues including reserve requirements.

Put simply, the banking came first creating the desire for reserves as an after-effect. The higher cost of acquiring reserves as a matter of Fed policy was not a deterrent, nor would it be.  Such added friction, a minor nuisance, only slightly reduced the higher profitability of an inflationary nominal environment such as what had existed for nearing a decade and a half by then.

Besides, there were other ways of meeting (rather, circumventing) requirements as well as liquidity needs that wasn’t in any of the M’s (it begins with the term “euro” followed by the technical denomination “dollar”).

As it turned out, there’d be only one way to (temporarily) derail this unstoppable monetary train.

“MS. TEETERS. So the possibility does exist that we could get a worldwide recession?”

Demand destruction to such an extent that not one but many economies around the world would plunge into contraction. The lack of reserves didn’t cause this, nor did, really, tightness in eurodollar availability.

Far bigger news to Americans and other people around the world late in ’79 had been the appalling news from Iran. In between the October conference call and this November meeting, the embassy takeover and hostage situation. More figurative gasoline to pour on the metaphoric flames blazing away at very real crude oil pricing.

While the FOMC was well-aware of the price effect oil was having on the economy, and going to continue having on CPI numbers, its members were also beginning to realize what was increasingly likely the next macro step completely out of their hands.

“MS. TEETERS. Ted, am I right that you rather markedly changed your outlook for [growth in] foreign economies, mainly because of the higher oil prices?”

The Fed’s staff did, indeed, come up with decidedly more pessimistic growth projections, but, as is standard with their models even to this day, they weren’t nearly pessimistic enough.

Even in November 1979, mere weeks before the 1980 recession would begin, the thinking was maybe one OECD economy might experience outright contraction while the rest, including the US, would merely slow down. As Ted Truman told Governor Nancy Teeters in response to the above question:

“MR. TRUMAN. Only in one of the major countries do we have what we call a recession, or negative growth. But we have [economic activity in] all the major countries dropping down--essentially growing at half the rate over the next four quarters that they had over the previous four quarters. And the last four quarters have been affected to some extent by the oil prices in 1979.”

For specifically the US, Truman said it would be slow, with GNP (what was used as a measure of output at the time) down around 1% to maybe 1.5%. And again, Ms. Teeters admirably nailed Truman on his mathematics-enthused forecast.

“MS. TEETERS. We’ve never managed to grow at 1 to 1-1/2 percent without sliding into a recession.”

There had been a concept called “stall speed” which was always in the back of everyone’s mind for good reason. The year 1980, as it turned out, would be no different.

From February 14, 1979, when protestors attacked the US embassy the first time, oil markets were on edge. Strikes in oil fields had erupted months before in ’78, and with the situation in Iran spiraling toward its Islamic Revolution, what had been around spot $16 a barrel (already painfully high after the 1973 oil embargo) found its way to $30 when the Fed’s provoking of the federal funds market reached its maximum.

By the time crude reached $40 a barrel by April 1980, higher in certain places, the US economy like many others around the world were gripped by a nasty recession.

Gasoline prices and shortages were more about a true supply shock, one that might be somewhat familiar to our current setting. American refineries were drawn up and built to receive and process particularly Iranian oil sent to our Gulf Coast by the friendly, frankly despotic Persian Gulf Shah government.

As production of Iranian oil declined, though it was made up in other types from around other producers in the world, for a time in the US the country would run out of gasoline while the refining process was retooled to accept and convert other kinds of crude.

The federal government, of course, made everything worse in between. There were price controls (no matter how these failed so spectacularly in ’71) which ended up rewarding refiners who hoarded what gasoline stocks they’d produced to sell at guaranteed higher prices in the future. Not only that, Uncle Sam’s system of allocation was typically bureaucratic, creating even more rigidity in supply.

The Department of Energy demanded large refineries share what usable crude supply they could obtain with smaller ones unable to get any. The latter being far less efficient would mean that, for a given quantity of oil, even less gasoline was produced at a time when a lot more was needed.

State governments got involved, with predictably worse results. Some limited gasoline purchases to $5 at a time, exacerbating the public tendency to buy gas frequently and always to the limit regardless of individual needs and use.

Supply. Supply. Supply.

Oil shock combined with stupidity, that was the 1980 recession, not Volcker.

Don’t believe me? Let’s go back to November 1979’s FOMC, from back then I’ll let Minneapolis Fed President Mark Willes sum things up:

“MR. WILLES. I have to admit that I don’t know what’s going to happen to the real economy. I’m not sure I even know how to go about predicting that at the moment because it seems to me that it depends so much on what OPEC does and what the Congress does [about oil] and lots of other things. I will go on to say, which will be no news to some of you, that in terms of policy it’s not clear to me that it makes any difference what the real sector does over the next twelve months because I’m not sure that we have any demonstrated ability to have an impact on that--in a predictable way anyway.”

The Volcker Myth was conjured much later to give a newly-reconstituted Federal Reserve its foundation legend. We’re led to believe in an always-almighty central bank that will even go so far as to use massively restrictive monetary policy to provoke nasty recession if it feels the need. As Willes straight admitted, there wasn’t even intent then.

What if the “central bank” was actually clueless about money, and, more to the point, affected only the narrow kind of slightly useful interbank token (bank reserves) as a byproduct of its random stabs of dart-throwing? How might everything look differently if you understood that oil and a supply shock, not Volcker, was responsible for recession in 1980?

It might look a lot like today, to be honest, especially in the bond market. The Fed’s going to do what the Fed’s going to do, but outside the short-run and short-run interest rates this won’t matter much at all.

Jeffrey Snider is the Head of Global Research at Alhambra Partners. 

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