Monetary Policy Is All Talk All the Time, and Always Has Been
(AP Photo/Patrick Semansky)
Monetary Policy Is All Talk All the Time, and Always Has Been
(AP Photo/Patrick Semansky)
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The situation in February 1981 was unexpected, which had simply become the norm. Oil prices from 1979 had put the US economy into a tailspin by the first half of 1980, a development which caught economists, politicians, and policymakers all off-guard. A vigorous, equally unanticipated recovery then took hold quickly by that summer and maintained itself into the following year.

 During this time, the Federal Reserve under Paul Volcker continued to pursue a policy of restricting bank reserves. The theory was simple: the Fed would limit the supply of reserves driving competition for them, which banks were required to hold against deposits, increasing their cost to a point it was thought to restrict bank credit. Limiting bank credit was the presumed long-sought key to ending the Great Inflation.

As to the first part of the plan, monetary policymakers were somewhat sticking to it. As I recalled several weeks ago, in its earliest stages of 1979 and 1980 officials buckled and supplied reserves with RPs (repos). They shifted after the recession to maintain a more determined pressure.

The problem, one of many, was in tying bank reserves to the effective money supply (which bank reserves aren’t) then to overall bank credit and finally to nominal economic outcomes. While it sounds easy, if several steps, by that point in monetary history it was the equivalent of sending a ball through a tortuous maze, a route only Rube Goldberg might be able to figure out ahead of time.

This was the issue the FOMC was wrestling with by February 1981, and, obviously, not for the first time. Despite tight reserves, all of a sudden the rate on them (tied to federal funds) slumped below the 15% floor which Volcker’s people had agreed to set.

Was this because money growth had slumped, too?

Policymakers had no real way to answer that question. On the unscheduled conference call held February 24, 1981, Volcker and his fellows tried to make sense of the situation while simultaneously wondering what, if anything, might be done about it. Staff economist Steven Axilrod plainly stated, “On the other hand, while the narrow aggregates are weak relative to the path the Committee set, the broader aggregates are generally strong.”

Using the more traditional transaction money aggregate M1 – by then split into M1-a and M1-b – it appeared as if money growth had indeed come down; way down, substantially less expansion than policy targets. However, for as little as there was coming in from the M1s, it was the opposite in broader monetary forms. M2 and M3 were still surging, well above targets while threatening to go higher yet.

It had taken policymakers a long time to figure out money itself was radically changed. All kinds of new transaction and interest-bearing accounts were tied together, money market funds and NOW accounts, even corporations leaning heavily on repo balances to settle real economy transactions (and let’s not forget, though it never came up back then, offshore eurodollar formats, too).

Any difference between the M1s and M2, really M3, was due to forever-changed bank and customer preferences; the former managing their liabilities with an eye toward minimizing reserve requirements and other frictions, the latter finally able to obtain interest returns on otherwise (under Depression-era Regulation Q) static transaction formats.

For banks seeing reserves in scarce supply, their cost driven upwards of 20% in early ‘81, shifting liabilities around as best as possible so as to avoid or at least minimize the levels of required reserves – while seeking to manage effective liquidity in wholesale markets rather than via these same reserves – was a no-brainer.

Peter Sternlight, the Open Market Account’s Domestic Manager, pointed out on the call that, “banks have large cumulative reserve deficiencies and they just are not acting on that basis at this point.” Or were they?

“MR. CORRIGAN. Again, I don't have any way of knowing this, but I just wonder if some of this flow into money market funds in the last six weeks or so may not be more of a shift of consumer-type accounts out of banks into the money market funds.”

It would make sense from any rational perspective. And if so, further sever the relationship between bank reserves and effective money, along with furthering the distortions between M1 to M2 and M3.

The call ended with not much being done, not because there wasn’t need for some official care rather due to the fact no one really knew what should be done. Instead, they’d wait to see how money markets played out.

“MS. TEETERS. We simply can't make the things reconcile at this point. So, let's let the market give us some indications as to what it wants to do.”

This situation wouldn’t become any clearer over the months following. The federal funds rate went back up, its February 1981 dip a temporary matter. In doing so, though, this offered no further clarity.

By July 1981, at the scheduled FOMC meeting for that month there was only more confusion. The M1s were down even more, while M2 and M3 still way too fast. All the while bank reserves remained restrictive and the funds rate sky-high.

With all that going on, a newly troubling development was piled on when long-term bond yields (Treasuries) began to fall compared to these high levels of short-term rates in federal funds or money equivalent Treasury bills. No one had yet formally tied together this curve inversion with high recession probabilities, though those at the Fed did realize it indicated rates overall were probably going to fall.

The question they now had to answer was, why?

“MR. WALLICH. Well, as long as the short-term rates are significantly above the long rates, people have an expectation that rates will come down. And that is why they're willing to pay very high rates temporarily.”

Many, including the staff and its models, thought this a good thing. In fact, this possibility might even lead the US economy to thread the needle, so to speak, where it would respond to higher short-term rates by calming down, slowing nominal growth, but as rates did go lower this would then cushion the slowdown leading to a sort of self-regulating soft landing (a term not yet developed).

Forecasts presented in July 1981 showed a serious deceleration, though not decline, in GNP (the output measure used back then) for the rest of that year before a small acceleration in the first half of the next year followed by more robust growth the remainder of 1982.

There was quite a lot of skepticism presented from both sides, a uniform agreement as to huge uncertainty. As such, most were willing to go along with these forecasts which precluded any recession in 1981 or 1982.

“MR. WALLICH. Any time the economy breaks out on the up side it will be pushed down again by rising interest rates. If we have a symmetrical policy, that would be true also on the down side. That is to say, any time the economy slows down interest rates will be pushed down if we keep the money supply on track. So, I wouldn't anticipate any very severe recession.”

As for the Chairman’s view, Volcker was, as usual, honest about how little he could figure (quite contrary to the Myth that’s been built up around him) given the lack of useful information in every respect.

“CHAIRMAN VOCKER. I also think conditions are softening in the economy, which may be optimistic compared to the view of some in the markets that even this level of interest rates wouldn't soften anything in the economy. I believe we are seeing, at the moment at least, some softening; but the burden of all the comments that were made around the table is that there is no simple way to get from here to there. I don't know whether the staff forecast or many of the other forecasts imply a fairly simple way. They don't imply big recessions or a big backtracking on inflation.”

The NBER today says that the recession of 1981-82 had already begun by the time this meeting took place; in fact, the group puts the start of what would become the nastiest, deepest post-war contraction (until 2007) in that very month.

Why couldn’t the models, or simple analysis, see it coming? After all, we’re told nowadays how this had been intentional; provoking recession by choking off bank reserves, a simple relationship that’s been put forward as the origin story behind Don’t Fight The Fed.

“MR. ROOS. Paul [Volcker], isn't it our purpose, though, to impose the discipline of monetary policy upon the banks? And won't the fact that they had to pay more teach them a lesson? Won't it teach them that if we want to discourage their extending credit, for example, that they have to take it seriously and not anticipate that we'll be there with the funds they need for their reserve requirements when they need them?”

While it was a neat idea, there’s just no evidence this is what actually happened. Accidental correlation implies nothing beyond it. On the contrary, bank credit data – two steps removed from bank reserves – showed that banks were only too happy continuing to extend debt; bank credit continued to accelerate from the post-1980 recession low right up until the moment the recession began in July 1981.

Demand for loans dried up as the economy went into a tailspin. To be fair, some of the FOMC members, Vice Chairman Anthony Solomon, in particular, had warned this was possible even if the vast majority of the committee sided with the staff projections.

Despite those, there was very limited confidence in any of it.

“MR. SCHULTZ. But it seems to me that this is only half of the problem. Half of the problem is that we don't know what the monetary aggregates are; the other half of the problem is that we don't know what the relationship is between the aggregates and GNP.”

Damn straight. They really had no idea what they were doing.

There just was no channel for policymakers to get from bank reserves through effective money availability affecting bank credit therefore the real economy. In fact, the whole argument about M1-a or M1-b, M2, M3, etc., was essentially trying to keep up – after the fact – with how banks had long before completely disengaged that process right at its beginning with bank reserves.

And it wasn’t going to get any better moving forward.

“MR. MORRIS. Well, Mr. Chairman, all this conversation, or much of it, suggests to me that we ought to face up to the fact that we do not know how to measure transactions balances in our present society. We have overnight RPs, for example, that are used by a good many corporations as transactions balances, and RPs are not in M-1B at all. I really don't think we will ever, from now on, be able to have a concept of a transactions balance in which we can have the same confidence we used to have in the old M1.”

So, what do you do if you are supposed to be a central bank but find yourself in this situation where you have no idea how bank reserves fit, and worse no one will ever be able to usefully describe (let alone measure) what’s money anymore?

You conjure a myth that everything which happened was planned out, that every outcome must’ve been by skillful execution of a purposeful design. Technocrats had meant for it all. You essentially have to fool the economy and the entire public into believing that yours is an all-knowing, all-seeing, all-powerful institution – and then ram home that narrative at every single opportunity.

As Ben Bernanke recently admitted, “I think monetary policy is 98% talk and 2% action, and communication is a big part.” As usual, his math is off; it’s all talk all the time and always has been.

Much of that “talk” is about what happened in the early eighties when Paul Volcker is said to have slain the Inflation Monster with his Mythical Sword of Money Knowledge.

Yeah, no.

There is no money in monetary policies, and there hadn’t been for decades prior to all this going down in the early eighties. Bank reserves just aren’t money, and there hasn’t been any correlation between them and real money, let alone the economy, for so long it shouldn’t be a question.

Keep this in mind as the yield curve today has been partly inverted for months, and Jay Powell aims to make his mark alongside Volcker’s with rate hikes and restrictive bank reserves. That much I have confidence Powell can accomplish; performing like the real Volcker had, recession and all. 

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

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