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The reform of October 1979: how it happened and why.

Point Four

As will be discussed more fully below in Point Eleven, Federal Reserve officials had long accorded a significant role in the inflation process to excessive monetary stimulus, along with the important effects imparted by "exogenous factors" that also affected measured inflation. As will be seen in that discussion, however, Chairman Burns had questioned the practical ability of monetary policy to resist the various pressures acting against sufficient monetary restraint to maintain price stability. In opposition to that view, the position of the monetarists had the intellectual attraction of purity--that, on a sustained basis, "inflation was always and everywhere a monetary phenomenon." This argument had a universal acidity that dissolved all other influences on long-term inflation, except for money growth. And the appreciable rise of actual inflation in association with often-above-target money growth brought ever-widening support for the monetarist argument that the culprit was none other than the Federal Reserve itself. Accordingly, it was ever-more generally perceived that controlling money growth was a prerequisite for controlling inflation.

That money growth had been excessively rapid entering the fall of 1979 could not really be questioned. In the third quarter of the year, the levels of M1 and M2 were 1 Vi percentage points below the upper bounds of their respective 3 to 6 percent and 5 to 8 percent ranges for the year only because of their respective low -2.1 percent and 1.8 percent rates of change recorded in the first quarter. With M1 and M2 growing at respective rates of 7.6 percent and 9.5 percent in the second quarter and of 8.6 percent and 11.9 percent in the third quarter, the Axilrod-Sternlight memorandum informed the FOMC that rates of growth have been accelerating and have been above the longer-run ranges, well above most recently ...

For the monetary aggregates as a group to be within their ranges by the time the year is over, a considerable slowing from their recent pace is required. (Axilrod and Sternlight, 1979, p. 2)

Taking a longer perspective, the two upper panels of Figure 5 show that, over each of the last four years of the decade of the 1970s, either M1 or M2 growth exceeded the upper bound of its announced annual ranged This experience, of course, had added empirical support for the contention that a causal link connected money growth and inflation. A decade after the procedural change, Stephen Axilrod summarized the approach as follows:

The obvious problem--it was an easy period in that sense--was to control inflation. One way to do it was to impose an M1 rule on yourself, pay little attention to GNP forecasts, and just let the economy adjust ... [The FOMC] used Ml successfully as that sort of bludgeon to receive a rapid reduction in inflation ... (Axilrod, 1990, pp. 578-79)

Monetarists buttressed their case by contending that monetary targeting on a consistent basis over time--that is, without "base drift"--would take advantage of the longer-run predictability of the velocity of money. Karl Brunner had underscored concern about base drift under the old operating procedures.

It [the Shadow Open Market Committee] also warned that the Federal Reserves internal procedures were ill suited to execute an effective monetary control. The traditional mode of implementing policy would remain, in the Shadow Committees view, an uncertain and unreliable instrument for the purposes defined by House Concurrent Resolution 133. The Committee emphasized, moreover, the potential drift built into monetary growth as a result of the peculiar targeting techniques evolved by the Federal Reserve Authorities. (Brunner, 1977, p. 2)

Effective monetary control would ensure, monetarists said, that prices would stay stable on average over time and therefore that inflation expectations at more distant horizons would be anchored at a low level. They contended that several economic advantages would flow from such a situation. They also argued that high and volatile inflation and inflation expectations made reliance on an interest rate as the main operating target for monetary policy even more problematic than it already was otherwise. After all, the significance for spending of a particular nominal interest rate was degraded as uncertainty rose about the true level of the real interest rate and as speculative investment gained in importance.

Point Five

A separate argument of monetarism was about how to control money growth, asserting that the monetary base or total reserves should be used as the operating target. (9) The Shadow Open Market Committee (SOMC) expressed the point this way in early February 1980:

The SOMC favors an immediate return to the 6% growth rate for base money that was achieved in the first and second quarters of 1978. A 6% average rate of growth of the base in each quarter of 1980 will continue the policy we advocated at our September 1979 meeting. (SOMC, 1980, pp. 6-7)

This monetarist argument was rejected by FOMC staff, which drew on a different strand of the literature to recommend nonborrowed reserves as the primary alternative operating target to the federal funds rate. But this strand of the literature did not contend that as a technical matter nonborrowed reserves were superior to the federal funds rate in an empirical horse race in which each approach was used optimally in setting an operating target based on the expected outcome for the money stock; rather, in such a case the two were virtually dead even in controlling money (Sivesind and Hurley, 1980, pp. 199-203; Axilrod and Lindsey, 1981, pp. 246-52).


Instead, what tipped the scales in favor of nonborrowed reserves was the practical observation that a monetary authority deliberately setting the funds rate would be unlikely to select the level that it expected to induce the targeted money stock because the implied volatility of the funds rate would be more than the authority could stomach. Because of what Governor Wallich called "inertia in the adjustment of the funds rate to needed levels under the old procedure," a nonborrowed reserves operating target was thought likely to work out better in practice in controlling money (Wallich, 1980, p. 5). Even if the authority chose an initial level that would not give rise to the appropriate funds rate for the targeted money growth, further automatic movement of the funds rate within the control period but outside the authority's discretion was believed likely to deliver monetary growth closer to its target than in the case of a funds rate operating target where the initial level was simply maintained. Over time, closer monetary management would imply that inflation would be brought under more certain restraint as well.

Point Six

The Committee recognized that the switch to a reserves-based approach to monetary control would be more likely to allow the federal funds rate in the short run to move as necessary to whatever level would prove consistent with more restrained money growth and lower inflation. But given that the appropriate level, as well as the induced automatic movement, could not be known in advance by the monetary authority, for the federal funds rate to have the scope to be significantly more variable, the Committee would have to establish a substantially wider permissible band of funds rate movement. This band, which was published in the directive, is portrayed in the lower panel of Figure 5 introduced in Point Four. On October 6, the Committee widened this band from 1/2 percentage point to 4 percentage points. The small crosses in that panel, which depict the average federal funds rate between FOMC meetings, also suggest that federal funds in fact began trading over a much wider range.

Figure 6 offers an alternative perspective: A standard forward-looking Taylor rule has a tendency to predict a funds rate from early 1976 through mid-1979 that not only exhibits fairly subdued movements but also comes reasonably close to the actual funds rate set by the FOMC. (Figure 6, it should be noted, does not even employ the effects of a lagged funds rate to capture the "interest rate smoothing" that the Committee unquestionably put in place along with its reaction to forecasts of inflation and real economic activity over virtually all of the decade of the 1970s [Orphanides, 2002]). The figures Taylor rule uses Greenbook forecasts of inflation relative to an assumed 2 percent target and of real GNP relative to the real-time estimates of potential output, as described in Orphanides (2003b). Other than its reliance on forecasts and data available in real time to the FOMC for its policy deliberations, it follows Taylors (1993) classic parameterization, including the coefficients he originally suggested for the Committee's responsiveness to inflation and the output gap and his assumption of 2 percent for the equilibrium real funds rate. Numerous studies over the past decade have suggested that adherence to such a policy rule should represent rather good, if not optimal, monetary policy and should be expected to deliver reasonably good macroeconomic performance. (10) By this rationale, and since the Committee's actions up to the summer of 1979 line up well with the Taylor rule prescriptions, policy should have been considered successful. However, it is precisely this reasoning that highlights the fragility of supposedly efficient Taylor rule prescriptions. The strategy of exact adherence to this rule would not have delivered much better outcomes than the policy in place before the reforms of October. And adherence after October 1979 would have prevented the tightening necessary for controlling inflation. Adoption of the new operating procedures shifted policy away from the pitfalls of the unreliable guidance suggested by the Taylor rule.


Point Seven

Chairman Volcker explained in 1992 that he did not believe that he would have been able to get the FOMC to accept overtly the increase in the funds rate that ultimately proved necessary to rein in inflationary money growth.

[T]he general level of interest rates reached higher levels than I or any of my colleagues had really anticipated. That, in a perverse way, was one benefit of the new technique; assuming that those levels of interest were necessary to manage the money supply, I would not have had support for deliberately raising short-term rates that much. (Volcker and Gyohten, 1992, p. 170)

Indeed, Chairman Volcker realized this potential difficulty with deliberate tightening in real time. Greider wrote,

Early in his tenure, Volcker had directed the senior staff to begin technical studies on changing the Fed's basic operating method, and after the embarrassment of the board's 4-3 vote on September 18, Volcker pushed the idea more aggressively. (Greider, 1987, p. 105)

Joseph B. Treaster put the point slightly differently in his book published in 2004.

In the middle of his second month as Fed Chairman, Volcker began developing a strategy for implementing what would be the single most important decision of his career. His insight, triggered by the reaction to the close vote, was that as confident as he felt at the moment, there might very well be a point, before inflation had been stopped, at which a majority at the Fed would say, No more. "When you have to make an explicit decision about interest rates all the time," Volcker said years later, "people don't like to do it. You're always kind of playing catch-up. I wanted to discipline ourselves."

His solution, which now seems breathtakingly simple, was to take the cutting-edge decision out of the hands of the members of the Fed--or at least make it seem that way ... (Treaster, 2004, pp. 147-48)

As Henry Wallich noted soon after the FOMC adopted the new procedures,

At the policy level, the reserve-based procedure has the advantage of minimizing the need for Federal Reserve decisions concerning the funds rate. Interest rates become a byproduct, as it were, of the money-supply process. (Wallich, 1980, p. 4)

William Greider quoted Governors Teeters, Rice, and Partee as to the desirability of automatic interest rate movements and their tendency to distance the outcome from the monetary authority's discretion.

"Under the new system," Nancy Teeters observed, "we could say what we were doing was concentrating on the monetary aggregates. It was perfectly obvious to me that if you set the money growth too low, that would send interest rates up. That was never in doubt. The problem with targeting the Fed Funds rate is that you had to set it. This did let us step back a bit."

Emmett Rice, who had joined the board four months earlier, had questioned interest-rate targeting himself, convinced that it would make more sense to control reserves directly ..." This meant you were not directly responsible for what happened to interest rates. This was one of the advantages. If interest rates had to go to 20 percent--and I have to say that nobody thought they would go that high--then this would be the procedure doing it. I wouldn't call it a cover, but I don't think anyone on the committee would have been willing to vote to push interest rates as high as 20 percent. This was a way to achieve a result, a more effective way to get there."

Chuck Partee, the other reluctant "dove," was attracted to the operating shift by a different argument. Partee was not a monetarist himself, but he thought that the monetarist approach might overcome a flaw in the Fed's institutional reflexes--sticking stubbornly with a strong position too long and causing more damage to the economy than it had intended ...

"It may sound odd, but I would prefer the evenhanded approach of the monetarists. I became very concerned about a mind-set that would lead us right in to a recession--get tight and stay tight ... I found myself far less hostile to the notion that we might have a fairer approach by targeting the money supply than I was to the idea that we should raise interest rates one time and keep raising them. The problem is, there is also a hesitancy to reduce interest rates once they have been raised. My concern grew out of my reflection on several earlier recessions, particularly 1974-1975. My concern was that we would be slow to respond to weakness and permit a substantial contraction in money and credit to occur. There would be a great chance of that, that we might just get locked into a position of holding tight for a rather extended period." (Greider, 1987, pp. 111-12)

Point Eight

Stephen Axilrod explained the import of the FOMC's implicit decision to renounce interest rate smoothing some 15 years after the new procedures were adopted.

[T]he Great Inflation [of the 1970s] ... came about because of an interaction of a culture of extreme policy caution and a number of unanticipated changes in the economic environment. That is, in the culture of the time the policy instrument, say, the funds rate, was adjusted very carefully--slowly and in small increments ... In that context you can think about the policy of 1979-82 as an effort to break the culture of extreme policy caution. (Axilrod, 1996, p. 232-33)

Point Nine

After October 6,1979, the FOMC set, and published in the policy record, short-run targets for money growth over the three months ending in the last month of the current quarter, based on the desired approach to the annual ranges that were announced in February and July in accord with the Humphrey-Hawkins Act. With the nonborrowed reserves path derived from these targets, along with the Committees initial borrowing assumption, the evolution of the actual federal funds rate between FOMC meetings would depend primarily on money-stock developments relative to the targets over that period.

This process obviously has nothing to do with Committee estimates of the NAIRU or of the associated estimates of potential output, nor does it have anything to do with gaps of unemployment or output from "full employment" levels. Actually, from a money-demand perspective, outcomes for the growth of the money stock in the current quarter have more to do with the growth of output ending in the current quarter than with an output gap (see, in particular, Orphanides, 2003b, Section 2.5). As Orphanides has pointed out, misestimates of the NAIRU and potential output and the associated misestimates of the unemployment and output gaps were primary causes of the inflation of the 1970s (Orphanides, 2002,2003a). Thus, it is understandable that the FOMC implicitly forswore gap analysis in the fall of 1979 (Orphanides, 2004; Orphanides and Williams, 2004).

Figure 7 provides a graphical illustration of the gap analysis-based dilemma. As seen in the middle panel, based on the available estimates of potential supply, actual output had fallen well short of potential output and the gap was projected to deteriorate even before the fears of recession appeared on the horizon in 1979. (11) This slack alone should have eventually led to a gradual easing of inflationary pressures, which can be seen in the forecast of inflation in the top panel. Throughout 1979, this reasoning suggested that holding back on tightening policy appeared to provide a reasonable balance of the Committees objectives, affording gradual disinflation and economic expansion. In retrospect, the 1979 estimates of potential proved overly optimistic, explaining why the policy prescriptions from this gap-based analysis were overly expansionary. But this was not recognized at the time. Continued adherence to gap-based analysis would have prolonged the policy of inappropriate, even if inadvertent, monetary ease. The policy reform in October short-circuited this process.



Point Ten

The monetary policy process of short-run money targeting also is not explicitly dependent on the longer-term economic forecasts of the Board members and Reserve Bank presidents. Although their sense of the outlook implicitly could affect the Committees money targets, initial borrowing assumption, and choice for the funds rate band, the influence of opinions about the future of the economy over the actual course of the federal funds rate is clearly less direct than with a federal funds operating target in which the Committee sets its operating objective based in important part on its opinion of the outlook.

This much looser connection between the stance of policy and the uncertain economic forecasts of FOMC members is, of course, consistent with Chairman Volcker's denigration of the accuracy of any economic forecasts that was cited above as well as Axilrod's earlier observation that after the adoption of the new techniques the FOMC avoided basing policy on forecasts. The new operating procedures, with their dependence on near-term outcomes for money, guaranteed that error-prone longer-term economic projections of both prices and real GNP would not interfere with the coming battle against virulent and entrenched inflation.

The Board staff's economic projection in mid-1979 did not offer an accurate outlook for real growth. Figure 7 confirms that, by July 1979, the Greenbook was predicting that a recession had begun by the second quarter of 1979, as clearly shown by the forecasted decline in the level of real GNP through the end of the year. (In retrospect, real GNP instead is known to have registered positive growth in each quarter of that year.) The lower panel of Figure 7 displays the associated staff prediction of a sharp rise in unemployment through the end of 1980. As a result of the projections by the time of the July Greenbook, of steep increases in the output and employment gaps, along with moderating energy prices, average four-quarter deflator inflation was foreseen to abate appreciably in 1980, after spiking through 1979.

The staff had established a history of excessive optimism in forecasting inflation in the 1970s. Figure 8 demonstrates this record visually. It presents for the 1970s the successive underpredictions of the average four-quarter rate of inflation in the deflator in mid-quarter Greenbooks-- plotted in the quarter of that Greenbooks publication--three quarters in advance of the last predicted quarter, as in the Taylor rule noted in Point Six. The bias in the inflation forecasts, of course, is closely related to the overly optimistic measures of potential supply discussed in Point Nine. The inflation forecasts were systematically lower than they should have been simply because of the persistent perceptions of economic slack that was not actually there. The evidence had not yet been assembled showing that basing inflation forecasts on real-time estimates of the output gap maybe unreliable (Orphanides and van Norden, 2003).

Point Eleven

With its actions on October 6, the Committee fully assumed its unique responsibility for the attainment of long-term price stability. To understand the nature of this change, it is necessary to discuss the attitudes of previous FOMCs.

Under Chairman Burns, the common thread running through many communications on monetary policy was that the Federal Reserve and other critical influences ultimately shared responsibility for the too-rapid rise in prices. Excessive fiscal deficits were a commonly referenced contributing source. The cost-push effect of union power through wage negotiations also was regarded as playing an important role, as was corporate discretion over administered product prices. After mid-decade, OPEC's cartel-like pricing was thought to influence not just relative prices but also overall trend inflation. By the 1970s, the economics profession had advanced sufficiently that most FOMC members had accepted a vertical long-run Phillips curve in which the equilibrium unemployment rate was independent of the inflation rate. Rather, despite rousing anti-inflationary speeches and testimony, the Federal Reserve had not really taken to heart its own sole responsibility for the average rate of inflation over the long pull. It is the central bank alone that has the duty of ensuring secular price stability, along with its other objective of promoting maximum employment or, relatedly, sustainable economic growth, in the intermediate term. These objectives were enshrined in the Federal Reserve Act in 1977.

Although he never mentioned this 1977 statutory addition, former Chairman Burns presented the 1979 Per Jacobsson lecture in Belgrade on September 30, entitled "The Anguish of Central Banking," in which he delved more deeply into the dilemma of monetary policymaking--attributing it to this fundamental factor:

the persistent inflationary bias that has emerged from the philosophic and political currents that have been transforming economic life in the United States and elsewhere since the 1930s. The essence of the unique inflation of our times and the reason central bankers have been ineffective

in dealing with it can be understood only in terms of those currents of thought and the political environment they have created ...

Inflation came to be widely viewed as a temporary phenomenon--or provided it remained mild, as an acceptable condition. "Maximum" or "full" employment, after all, had become the nations economic major goal--not stability of the price level...Fear of immediate unemployment--rather than fear of current or eventual inflation--came to dominate economic policymaking ...

Viewed in the abstract, the Federal Reserve System had the power to abort the inflation at its incipient stage fifteen years ago or at any later point, and it has the power to end it today. At any time within that period, it could have restricted the money supply and created sufficient strains in financial and industrial markets to terminate inflation with little delay. It did not do so because the Federal Reserve was itself caught up in the philosophic and political currents that were transforming American life and culture ... (Burns, 1979, pp. 9,13,15)

Chairman Burns gave the following basic reason for why the role of the central bank in fighting inflation in a democracy would be "subsidiary" and "very limited," thus rendering it able to cope "only marginally" with inflation, causing him to think that "we would look in vain to technical reforms as a way of eliminating the inflationary bias of industrial countries" (Burns, 1979, pp. 21-22):

Every time the Government moved to enlarge the flow of benefits to the population at large, or to this or that group, the assumption was implicit that monetary policy would somehow accommodate the action. A similar tacit assumption was embodied in every pricing or wage bargain arranged by private parties or the Government. The fact that such actions could in combination be wholly incompatible with moderate rates of monetary expansion was seldom considered by those who initiated them, despite the frequent warnings by the Federal Reserve that new fires of inflation were being ignited. If the Federal Reserve then sought to create a monetary environment that fell seriously short of accommodating the upward pressures on prices that were being released or reinforced by governmental action, severe difficulties could be quickly produced in the economy. Not only that, the Federal Reserve would be frustrating the will of Congress--a Congress that was intent on providing additional services to the electorate and on assuring that jobs and incomes were maintained, particularly in the short run.

Facing these political realities, the Federal Reserve was still willing to step hard on the monetary brake at times--as in 1966,1969, and 1974--but its restrictive stance was not maintained long enough to end inflation ... As the Federal Reserve...kept testing and probing the limits of its freedom to undernourish the inflation, it repeatedly evoked violent criticism from both the Executive establishment and the Congress and therefore had to devote much of its energy to warding off legislation that would destroy any hope of ending inflation. This testing process necessarily involved political judgments, and the Federal Reserve may at times have overestimated the risks attaching to additional monetary restraint. (Burns, 1979, pp. 15-16)

In essence, Burns suggested that if a central bank had committed the expansionary errors that generated inflation, as had happened in the late 1960s and 1970s in the United States, public and political support appeared necessary to maintain the much tougher policies that might be required to restore stability. Without such support, it could be questioned whether a central bank had the mandate for such action. Nonetheless, Burns ended his lecture on an optimistic note, observing that the political environment was indeed shifting in that direction.

When Chairman Volcker was appointed to the Board, public support of anti-inflationary action had become quite high, and political sentiment appeared much more conducive than ever before to strong actions resisting inflation. By the late 1970s, public opinion polls consistently identified inflation as a greater problem than unemployment. In any event, Chairman Volcker said in an interview on PBS's Commanding Heights (2000) that he had listened to and been much affected by this lecture by Chairman Burns before he returned to Washington. He thought that Chairman Burns was saying that as a practical matter the Federal Reserve was "rather impotent" in fighting inflation. While that might have been the case earlier in the decade, Chairman Volcker obviously disagreed that this assessment was still correct in 1979. In retrospect, he was right. The FOMC at the end of the day proved able to live up to its obligation of being responsible for establishing and maintaining stable prices over time.

Point Twelve

That a tightening of monetary policy could evoke "violent criticism" by "frustrating the will" of a Congress intent on "assuring that jobs and incomes were maintained," as Chairman Burns contended, can be supported from the contemporaneous statements about the economic goals of the elected officials themselves. For example, on October 19,1979, the Senate majority leader, Robert C. Byrd, Democrat from West Virginia, declared the following:

Attempting to control inflation or protect the dollar by throwing legions of people out of work and shutting down shifts in our factories and mines is a hopeless policy. (Greider, 1987, p. 149)

As another example, Representative Henry S. Reuss, Democrat from Wisconsin, chairman of the House Committee on Banking, Finance, and Urban Affairs, said this after the four-to-three vote on the discount rate on September 18,1979:

For the first time, Fed members are wondering out loud whether it really makes sense to throw men and women out of work, and businesses into bankruptcy, in order to "rescue the dollar" by chasing ever-rising European interest rates. (Berry, 1979, p. A1)

Although Representative Reuss was a general supporter of the new operating procedures, at Chairman Volcker's first Humphrey-Hawkins testimony on February 19,1980, this is what he said:

Last year, following our first hearings, under the procedures established in Humphrey-Hawkins, we issued a report on March 12, 1979, agreed to by all except one of our members.

The key recommendation of that report was "anti-inflationary policies must not cause a recession."

So far, the Federal Reserve's policies have not caused a recession and for that, you deserve our appreciation ...

The Federal Reserve cannot cure inflation with monetary shock treatment and it shouldn't try. (U.S. House of Representatives, 1980b, pp. 1-2)

In 1982, with the economy having slid into a recession, both Republicans and Democrats introduced legislation that would have required the Federal Reserve to keep real interest rates within the range of historical experience, which could have potentially interfered with the conduct of monetary policy in a damaging manner.

In Point Three above, we saw that the IMF noted "that it is evident that governments have felt severe economic and political constraints in launching an effective anti-inflation program, since in the short run this would be bound to have severe employment effects." Perhaps in part to circumvent those political constraints, the FOMC members appreciated that the new procedures distanced them from the setting of the funds rate, as Point Seven demonstrated, and Chairman Volcker's answer to the question about real-side impacts in the press conference on October 6, as quoted above, was sufficiently noncommittal that William Greider claimed that "he evaded the point and concealed his real expectations" (Greider, 1987, p. 123).

But these inferences inevitably enter into the realm of speculation, because the motivation of participants in the onrush of history is rarely specified at the time. Even so, it is difficult to escape the conclusion that potential criticisms of FOMC policy by politicians, who in coming years actually would show stirrings--by introducing legislation--of using their power to affect the FOMCs makeup or freedom of action, engendered in Committee members the desire to obscure their responsibility for real-side developments.


Indisputably, market participants were somewhat confused, especially early on, by what the new procedures were and what they portended for monetary aggregates and the money market, let alone for longer-term interest rates, real magnitudes, and inflation. One diagnosis would be to highlight a failure by the Federal Reserve to communicate the nature of its new policy approach soon enough and with enough specificity to satisfy the public s, and especially market participants', pressing desire to know. In particular, between October 6,1979, and February 1,1980, the FOMC did not release any detailed summary of its new technique. In consequence, at its meeting on February 3-4,1980, (12) the SOMC held that

[t]he Federal Reserve should announce further details about its procedures to reduce the longrun trend of money growth and reestablish its credibility by actually achieving its announced targets. This would be the most effective way to eliminate the entrenched belief that the rate of inflation will continue to rise in the Eighties. (SOMC, 1980, p. 2)

Was one reason for this reticence that the FOMC was operating under a legacy of secrecy inherited from the tenures of Chairmen Martin, Burns, and Miller? (See, Goodfriend, 1986.) Could this tradition be used to explain, at least in part, why, for example, the Axilrod-Sternlight memorandum was not released immediately? Immediate release of this memorandum shortly after October 6 would have revealed, for all the world to see, a systematic, considered monetary policy approach.

An alternative diagnosis would be that existing contingences, inevitable complexities, the intended audience, and unavoidable uncertainties all posed severe challenges to clear communication, which could be surmounted only over time. As has already been seen in the historical record, the FOMC actually had adopted the new operating procedures on a temporary, contingent basis, awaiting evidence on just how effectively they would work given the uncertainties involved, including those regarding money demand (FOMC Transcript, 10/6/1979, pp. 9-10,15). However, as Peter Sternlight learned, presumably to his chagrin, it is difficult to make the point initially that new procedures have "experimental" elements without seeming to undercut the resolve and understanding of the agency implementing them. As the rational expectations revolution has emphasized, a "permanent" commitment has a much more powerful effect on expectations than a "temporary" one. To be sure, the FOMC did not stress publicly the contingent nature of its adoption of the new operating technique. Still, the Committee did not discuss and reaffirm its earlier tentative decision to adopt the new approach until it met on January 8,1980. Only afterward was Chairman Volcker ready to release publicly the "technical" description of the new procedures, which he did on February 1,1980.

In addition, the new procedures, without question, were complex. The Axilrod-Sternlight memorandum, which describes the essence of the new procedure, was composed as a background paper presenting a policy choice to the FOMC, for which their writing was well suited. It certainly was not written with the simplicity and pedantry needed for public consumption. Financial market participants are trained and paid primarily to buy low and sell high. Admittedly, they have a longer attention span for digesting, and a greater capacity to grasp, Federal Reserve analyses describing the intricacies of monetary policymaking than does the public at large. But even with a hypothetical manual containing a perfect prediction and complete elucidation of what the new procedures would be and how they would work, it is probable that market participants would have been able to assimilate the main features of those procedures only gradually from practical experience.

Furthermore, certain features simply could not have been known by the Federal Reserve in advance. Although the basic procedures had been considered before their approval on October 6,1979, some elements could not have been settled except through the passage of time. Initially, these inherently uncertain, and thus imperfectly describable, features included (i) how aggressive the FOMC would be in setting and varying the monetary target paths, the initial borrowing assumption, and the band for allowable funds trading; (ii) how extensive intermeeting policy-related adjustments to the nonborrowed reserves target path would be; (iii) how extensive intermeeting technical "multiplier" adjustments to the nonborrowed reserves target path would be; and (iv) how responsive the monetary aggregates, the real economy, and inflation would be to these various ministrations.

FOMC communication, operating within this context, naturally had the obligation to strive for maximum conciseness and clarity; but in judging the Federal Reserve's success in public communication in this case, especially late in 1979 and early in 1980, a historian must carefully parse the words used by the principals. Take as an example the interview that appeared in the WSJ on October 11, in which a contemporary reader may not consider the "Fed official" to be a paragon of clear communication (see p. 206). But such a reading risks misinterpreting the meaning of the words used in what arguably was an informative description of a complex, responsive, and discretionary monetary policy approach.

First, a "rule of thumb" was meant to convey something that the Federal Reserve certainly was not going to propound: an oversimplified summary of a complex underlying system. Second, at the time, the word "rule" by itself had a different meaning than it does today because John Taylors famous usage, which has been adopted by the profession, has altered its definition among economists to mean merely a "guideline" subject to judgmental overthrow. Then, the word "rule" had been used influentially by Milton Friedman in the "rules versus discretion" debate to mean a legislated requirement that would have to be followed strictly. Besides "nondiscretionary," a "rule"--also unlike todays sense--was "nonresponsive" to current business cycle developments as well, as in Friedmans k-percent money growth rule or Allan Meltzer's monetary base growth rule. Only later did Allan Meltzer and Bennett McCallum introduce and advocate variable base growth in a nondiscretionary rule, explicitly employing the concept of a "responsive, nondiscretionary rule" (Meltzer, 1987; McCallum, 1988). Third, the word "unpredictable" apparently did not pass the Fed officials lips; instead, it was the reporters word, although Chairman Volcker did believe that some "uncertainty" about future monetary policy settings could be useful in curtailing "speculation" (Volcker and Gyohten, 1992, p. 170). Finally, todays vantage point makes it clear--although it may have been less clear in the interview--that the "Fed official" was saying, not that a thought-out systematic structure of the new procedures did not "exist" (since it certainly did in the Axilrod-Sternlight memorandum), but rather that the Federal Reserves "future behavior" hadn't taken place and obviously couldn't yet be pictured in detail. Only the passage of time could clarify the emerging contours of the operational landscape.


In attempting to draw lessons for the present day from the October 1979 policy reform, it seems necessary to classify the essential characteristics that made Chairman Volcker's FOMCs successful at fighting inflation and setting the stage for Chairman Greenspan's FOMCs to finish the job. This section addresses the questions of whether Chairman Volcker was (i) a monetarist? (ii) a nominal income targeter? (iii) a new, neo, or old-fashioned Keynesian? (iv) an inflation targeter? or (v) a great communicator?

A Monetarist?

Chairman Volcker's scientific views on the merits and demerits of the doctrine of monetarism arguably changed little during his years as president of the New York Federal Reserve Bank and Chairman of the Board of Governors, judging by various FOMC transcripts, speeches, and testimony. As already seen, he subscribed to the long-run connection between average money growth and inflation, although some (but not all) nonmonetarist macroeconomists at the time would have agreed with this secular linkage. He also expressed this point of view in September 1976, when he presented an extended analysis of monetarism to an academic audience. He first characterized the school not only as having correctly insisted that money matters but also as having

usefully emphasized the danger of confusion between nominal and real rates and the role of price expectations. They have forcefully made the case for the view that in the long run velocity is not related to the stock of money and that, in the same long run, an excess supply of money contributes not to real income or wealth but simply to inflation. (Volcker, 1976, p. 251-52.)

However, he then prophetically noted that

no one should be under the illusion that any tactical change will end controversy that, in the last analysis, stems more from different judgments about relevant policy variables than about operating techniques. (Volcker, 1976, p. 253)

He outlined many of the disadvantages to money targeting that in the second half of 1982 would ring the death knell, though admittedly at first in a muted way, to monetary targeting at a low growth rate:

[This points out] the simple fact that, whatever the stability in the relationship between money and nominal income in the longer run, there is considerable instability in the relationship over time horizons relevant to policymakers. Certainly the relationships between money, interest rates, and nominal income have been unusual over the year or so since I rejoined the Federal Reserve ... I can only conclude that, in periods such as that we have just been through, we need to be alert to possible shifts in the demand for money. (Volcker, 1976, p. 252)

He continued as follows:

[W]e must constantly balance the danger of underreacting to deviations of the aggregates from target paths against the danger of overreacting ... Clearly, there are risks in not responding to bulges or shortfalls in the money supply relative to objectives ...

But the danger of overreacting to deviations in the aggregates from targets is just as real ...

Attempts to respond immediately to shifting reserve availability and allowing the money market abruptly to tighten or ease could therefore easily result in whipsawing of the market ... Since only a relatively small fraction of the impact of a given move in reserve availability or money market conditions is reflected in the behavior of the monetary aggregates in the short run, very large movements in reserves and money market conditions might be needed to correct short-run aberrations. Worse, the lagged effect of these moves might then have to be offset by even larger movements in the opposite direction in the subsequent period-a process that could easily lead to a serious disruption of the whole mechanism. (Volcker, 1976, p. 254)

He argued that if a central bank turns toward significant monetary restraint, it can induce difficult reactions on the real side, with broader ramifications.

It is hardly a satisfactory answer to say that central banks in principle can always resist inflationary pressures by simply refusing to provide enough money to finance them. Set against persistent expansionary pressures, aggressive wage demands, monopolistic or regulatory patterns that resist downward price adjustments, and other factors affecting cost levels, such an approach would threaten chronic conflict with goals of growth and employment that must rank among the most important national objectives. In a democracy, the risk would not be just to the political life of a particular government, but to our way of government itself ...

In this larger social and political setting, we should perhaps think of central banks themselves as "endogenous" to the system. A theory of chronic inflation that points only to the money supply is not going to prove adequate to understand-or deal with-inflation in today's world.

The danger is that it may discourage the search for particular remedies for particular problems ... The monetarists, emphasizing old truths in modern clothing, have provided a large service in redressing the balance. It is in pressing the point to an extreme that the danger lies-the impression that only money matters and that a fixed rate of reserve expansion can answer most of the complicated problems of economic policy. (Volcker, 1976, pp. 255-56)

As to the monetarist arguments on technical issues of operating procedures, he also articulated positions that foreshadowed the FOMC s side in future debates and in the Staff Study in 1981.

While I do not pretend to econometric expertise, I do know that a massive amount of research has been conducted in this area. The apparent result is that the relationship between money and reserve aggregates, particularly in the short run, appears no more reliable than the relationship between interest rates and money ...

We have techniques to make the needed forecasts with both the interest rate and reserve approaches. The trouble is that the forecast errors are large no matter what procedure is used, particularly over periods of one to three months. Indeed, unimpressive as they are, I am told some of the correlations observed in the historical data between reserve measures and monetary measures would prove to be spurious under a regime of rigid reserve targeting. (Volcker, 1976, pp. 253-54)

When the entire 13-paper Staff Study (BOG, 1981) was published, the Federal Reserve gave the results a lot of play, ranging from an extended discussion in the February 1981 Humphrey Hawkins report, to a press conference, to two conferences for economists (the conference for academic economists was April 17,1981, with lead-off statements from Karl Brunner and Stephen Goldfeld, and the conference for market economists was April 21,1981), to a Federal Reserve Bulletin article by Stephen Axilrod (1981).

Monetarists did not believe that the FOMC had gone nearly far enough in the reforms of October 1979 and seized on the Staff Study to reiterate their points. Milton Friedman critically reviewed the experience (Friedman, 1982). Peter Sternlight and Stephen Axilrod vied in person with Robert Rasche and Allan Meltzer in a heralded debate on April 30,1981, at The Ohio State University (Rasche et al" 1982). Even so, two of the Staff Study's papers were published by Karl Brunner, editor of the Journal of Monetary EconomicsM In addition, at a conference held at the Federal Reserve Bank of St. Louis in October 1981, David E. Lindsey was asked to examine the institutional changes needed to improve control of the money stock. Even during the period of monetary targeting, Chairman Volcker made his skeptical opinion of monetarism plain, first to Congress and then later to his FOMC colleagues.

Chairman Volcker ... I would remind you that nothing that has happened-or that I've observed recently-makes the money/GNP relationship any clearer or more stable than before. Having gone through all these redefinition problems, one recognizes how arbitrary some of this is. It depends on howyou define [money]. (FOMC, Transcript, 1/8-9/1980, pp. 13-14)

Finally, the FOMCs departure from low-growth monetary targeting after mid-1982, and the subsequent downgrading of Ml itself as well as replacement of nonborrowed reserves with borrowed reserves in the fall of that year, which are beyond the scope of this paper, suggest as well that Paul A. Volcker did not qualify as a monetarist.

A Nominal Income Targeter?

Nominal income targeting was in the air in the late 1970s and early 1980s in the writings of James Tobin, Bennett McCallum, Robert Gordon, and others. In a sense, money and nominal income targeting could be viewed as closely related. Indeed, to emphasize this point, James Tobin even referred to GNP targets as "velocity adjusted aggregates" (Tobin, 1985). Thus, the following quotation from Chairman Volcker's 1981 Humphrey-Hawkins testimony perhaps could be read as the statement of a closet nominal-income targeter:

I would like to turn to the targets for 1981. Those targets were set with the intention of achieving further reduction in the growth of money and credit, returning such growth over time to amounts consistent with the capacity of the economy to grow at stable prices. Against the background of the strong inflationary momentum in the economy, the targets are frankly designed to be restrictive. They do imply restraint on the potential growth of the nominal GNP. If inflation continues unabated or rises, real activity is likely to be squeezed. As inflation begins noticeably to abate, the stage will be set for stronger real growth. (Volcker, 1981, pp. 5-6)

However, this interpretation would be inaccurate. To be sure, monetary targeting would constrain the growth of nominal GNP, which is what Chairman Volcker was pointing out. But literal nominal GNP targeting would not have met with his approval, at least in the environment facing the Committee in 1979, for two reasons at a minimum.

First, a more directly controllable intermediate target than GNP was necessary to restore the publics confidence in the Federal Reserve's commitment to conquering inflation. While policy could be adjusted to maintain Ml growth within an announced range over relatively short periods, thus demonstrating that the Federal Reserve meant business, that could not be said of a nominal GNP target. The lags in the transmission process were, as they remain, too long, uncertain, and variable for that purpose, and too many other factors outside a central bank's control influence nominal income over short intervals. Second, nominal income targeting would not have represented as stark a break from the gradualist policies of the past as the Committee must have felt was necessary. As described by Tobin, and in light of the policy lags involved, nominal income targeting would require the central bank to continue to fine-tune the stance of policy on the basis of predictions of the future, hardly a recipe for success given the profession's sad forecasting record earlier in the 1970s. Stephen Axilrod later offered the following summary regarding the superiority of monetary targets:

A money supply guide has two virtues: the central bank can be held reasonably responsible and accountable for its achievement, and it will serve as an anchor to the windward against erroneous assessments of ongoing and predicted economic and price developments. (Axilrod, 1985, p. 600)

In 1979, Chairman Volcker himself clearly put predominant priority on conquering inflation. Nominal GNP targeting did not appear as certain a strategy for gaining the public's confidence and for fairly promptly achieving that goal as monetary targeting did.

A New, Neo, or Old-Fashioned Keynesian?

A basic policy recommendation arising from the Keynesian framework, old, new, and neo-, is that policy can be successful in stabilizing the economy by aiming to align aggregate demand with the nation's potential supply. In one sense, the theoretical argument behind this reasoning is impeccable, under the assumption that the implied policy prescription can be applied in practice. But Volcker rejected the premise that policy should actively seek to close output or unemployment and related gaps, judging that the informational requirements of such calculations were simply untenable.

The original Taylor rule, which used outcomes for the estimated output gap, that is, actual output less potential output, provides a useful illustration of the gap-closing Keynesian perspective. But unlike this Taylor rule, the reaction function consistent with targeting money growth instead, from a money-demand perspective, would use outcomes for estimated output growth. That is, whereas the Taylor rule stresses the role of the output gap for setting policy, a reaction function for controlling money growth would instead stress the growth rate of output relative to that of potential-that is, the change in the output gap. And indeed, estimated policy reaction functions suggest that, while Federal Reserve policy appeared to respond to such gaps quite strongly before Volcker became Chairman, this was no longer the case afterward (Orphanides, 2003b, 2004).

Because he had little tolerance for gap analysis, it is clear that he should not be placed in any of these camps. It is less certain that these camps were any more tolerant of inflation than he was, but he obviously had a very low tolerance for inflation.

An Inflation Targeter?

Does that mean that he anticipated today's advocates of inflation targeting, such as Governor Ben Bernanke, Thomas Laubach, Rick Mishkin, Adam Posen, and the current IMF or the central bank practitioners in New Zealand, Australia, Canada, England, Sweden, Korea, Poland, and South Africa? (15) Not really, to the extent that they attempt to heighten central bank transparency through an announced, explicit numerical target or range for the inflation rate. Instead, in a speech before an audience of academics in 1983--jocularly called "Can We Survive Prosperity?" (16)--Chairman Volcker proposed a qualitative definition of price stability.

A workable definition of reasonable "price stability" would seem to me to be a situation in which expectations of generally rising (or falling) prices over a considerable period are not a pervasive influence on economic and financial behavior. Stated more positively, "stability" would imply that decision-making should be able to proceed on the basis that "real" and "nominal" values are substantially the same over the planning horizon-and that planning horizons should be suitably long. (Volcker, 1983, p. 5)

His disdain for forecasts as a policymaking tool also would have turned him against some recent practices for attempting to attain an inflation target. All things considered, he certainly didn't sound like a prototypical inflation targeter.

A Great Communicator?

In his days as president of the New York Federal Reserve Bank, he referenced approvingly the degree of openness in the policy record:

I might note in passing that the amount of information provided in these records probably sets a standard among the major central banks in the world, and represents a degree of openness entirely unknown to a central banker of an earlier generation. (Volcker, 1976, p. 253)

Chairman Volcker advanced the case for effective communication early in his tenure at the Board, as well as the advantages of monetary targeting in this regard.

All of this puts a special burden on those of us developing and implementing policy to "get it right," to communicate our purposes and intentions effectively, and to persevere with needed policies.

In that context, I am satisfied that the greater emphasis we have placed on monetary targeting in recent years, supplemented by the change in operating techniques, has assisted both in communicating what we are about and achieving the internal discipline necessary to act in a timely way. (Volcker, 1980f, p. 6)

For the not-quite-three years of serious (if not always effective) short-term monetary targeting, FOMC communication indisputably was more transparent than in the surrounding years, when the FOMC did not intend for its communication to be very open-and succeeded admirably in realizing its intention. Despite the transparency under monetary targeting, the Committee was accused of adopting the new operating procedures only as a smokescreen to obscure its intention to markedly increase short-term interest rates. We have found no evidence to substantiate this claim and therefore consider it invalid. Instead, what does make for a fascinating debate, as there are two legitimate sides, is whether the Committees communication during the period of monetary targeting moved toward openness as completely as it should have. In what follows, we try in a single discussion to give the flavor of each side of the debate.

The fanfare surrounding the announcement of the new procedures, the testimonies of Chairman Volcker and other Board members, the speeches by Board members and Reserve Bank presidents, the Humphrey-Hawkins reports, the official staff studies, the Bulletin article, and the unofficial staff papers must have served a communications end. The general principles underlying the new approach were well explained, and the FOMC, if only by dint of repetition, must have gotten these messages across over time, at least to some extent.

To be sure, the Committee convinced most observers that it meant business in large measure only by successfully reducing actual inflation as time went on. Survey responses regarding inflationary expectations and long-term interest rates did not respond immediately to the Federal Reserves new operating procedures and associated stirring words; instead, it took some years, along with the reduction in actual inflation, for them to come down on a sustained basis. Market participants understandably would have been somewhat skeptical initially that real reforms would continue when the going got rough, so they needed to see the lower inflation results before they would fully believe that a "regime change" had occurred. Whether publicly quantifying its inflation goal would have allowed the FOMC to shorten this period of adjustment can be debated. In any event, observers on the outside from the beginning could see the new operating procedures working themselves out in money markets as advertised in those Federal Reserve descriptions. While the Federal Reserve did not publish its short-run target paths for Ml and reserves, let alone the Federal Reserves daily balance sheet or the reserve factor forecasts made by staff at the Trading Desk and the Board, most people on the outside did not care to know about the detailed plumbing of the new monetary control procedures. (17) Instead, they just wanted to be sure that those on the inside were in fact minding the store and would "get it right," in Chairman Volcker s phrase.

The communications problems that did emerge concerned the public's basic understanding of exactly what constituted "getting it right," because effective monetary targeting proved to be no easy matter. Although beyond the scope of this paper, the increasing challenges of monetary targeting and the eventual departure from it via a nonborrowed reserves-based operating procedure, whatever the departures merits or demerits, in Chairman Volcker s mind clearly could not be discussed openly-despite its only temporary adoption in the first place-perhaps partly in light of the favorable public comments the FOMC had made about the approach.

This brings us to the basic question of whether Chairman Volcker could be classified as a great, or even mediocre, communicator? One aspect of this question in turn can be decomposed thusly: Was communication about the future stance of policy transparent, and why or why not? Was communication about the present stance of policy transparent, and why or why not?

The first component question is the easier to answer. As a simple matter of pure logic, knowing and revealing publicly anything about the future stance of policy requires knowledge not only about the FOMC's ultimate objectives and future reaction function but also about the outlook for economic activity and inflation. As the historical narrative repeatedly demonstrated, Chairman Volcker was not just skeptical about but almost dismissive of economists' attempts to forecast the future. Indeed, he expressed the view that basing policy on such efforts had proven to be a counterproductive strategy in the 1970s. Given that attitude, he certainly would not have wanted the central bank to suffer the indignity of having its public statements about its own future policy stance, which necessarily would have had to rest on those same error-prone forecasts, frequently proven wrong by the march of events. This was obviously the case during the episode of monetary targeting. Even after the fall of 1982, when the Committee was instructing the Desk to pursue a borrowing operating target, the FOMC did not try to hint at what the future level of borrowing might be.

The answer to the second component question, about publicly describing the current policy stance, is much more difficult to prove--though not to provide--because it is necessarily more speculative. People tend not to express "politically incorrect" sentiments--to use the term former Governor Laurence Meyer has recently employed in a different macroeconomic context--on the record for historians later to uncover (Meyer, 2004, pp. 75-76). Thus, much of what follows cannot be conclusively demonstrated, but is based on the "atmospherics" around the Board in the 1980s (David Lindsey's recollection). A major role was played by political threats to FOMC independence, which also is largely beyond the scope of this paper, as is politicians' switch to deploying an altogether different strategy in the first half of the 1990s, which involved certain issues of transparency, and naturally induced an alternative defensive posture by the Federal Reserve. The post-1982 threats to Federal Reserve independence came from members of both parties in the Congress and fed back on the lack of transparency of the Federal Reserve under Chairman Volcker. Particularly in the post-monetary-targeting portion of his tenure as Board Chairman, the FOMC was guarded in its communicative detail. Indeed, the FOMC of this period revealed its propensity for "constructive ambiguity," a term that always could be used in polite company. A less-inhibited modern observer instead might call the Committee "opaque" or, even worse, "non-transparent."

Actually, what is not so transparent to the modern observer was precisely the Committee's defensive motivation at the time. An important concern was to avoid criticism, which could well have resulted in political pressure, which in turn could well have adversely affected the conduct of monetary policy. It is worth remembering that congressional criticism of what would now be termed sound, anti-inflationary monetary policy was not uncommon at the time. Sharp criticism of interest rate hikes by politicians, who ultimately might be successful in passing legislation altering the Federal Reserve's makeup or limiting its maneuvering room, would only render an already difficult decision to tighten even more difficult.

Without transparency, a decision that likely or certainly would have raised the funds rate, but not the discount rate, would not have been known even to the market cognoscenti any earlier than the next day through the signals imparted by the operations of the Trading Desk. And the action might or might not have been covered in financial news stories on the business pages of the newspapers, but not before the day after that. By then the news would have been sufficiently outdated that few politicians would have bothered to comment in real time.

By contrast, with the transparency of, for example, an immediate announcement of a change in the stance of policy, reports by the media would have been immediate. Commentators, including politicians, would have given their reactions on camera the same afternoon. The story would have been covered in the television news programs that evening and then would have appeared on the front pages of the major newspapers the next day. In other words, transparency would have transformed the action from a little-noticed technical adjustment in the obscure market for bank reserves into a big deal. In the resulting goldfish bowl, tightening would have been harder to decide to do--yielding worse monetary policy and hence inferior national economic results.

In light of these considerations, Volcker s advice to a "new central banker," as recounted by Mervyn King, is entirely understandable:

When I joined the Bank of England in 1991,1 was fortunate enough to be invited to dine with a group that included Paul Volcker. At the end of the evening I asked Paul if he had a word of advice for a new central banker. He replied--in one word--"mystique." That single word encapsulated much of the tradition and wisdom of central banking at that time. (King, 2000)

This advice is, of course, not that of a great communicator.


The fundamentally negative answers to the last several questions imply that Chairman Volcker cannot readily be pigeonholed. To be sure, he unswervingly held to the end of vanquishing inflation. However, he was pragmatic in his choice of means. Paul A. Volcker, whose FOMCs went much of the way to conquering inflation, was a true original.


Inflation was well entrenched in the United States by the time President Carter appointed Paul Volcker Chairman of the Federal Reserve in 1979. For more than a decade, the Federal Reserve had attempted to cure the problem with a seemingly appropriate gradualist approach. By nudging short-term interest rates in small steps, monetary policy could be sufficiently expansionary to support reasonably high employment and growth, thereby avoiding recession, while at the same time restrictive enough to maintain some slack in aggregate demand, thereby making progress on inflation. In theory, by focusing on short-run demand management, both economic stability and gradual progress on inflation could be attained. Instead, this approach delivered instability and an ever-worsening inflationary psychology.

In 1978, Paul Volcker had already recognized that an approach placing greater emphasis on controlling inflation, instead of the strategy in place, would be more fruitful.

Wider recognition of the limits on the ability of demand management to keep the economy at a steady full employment path, especially when expectations are hypersensitive to the threat of more inflation, provides a more realistic point for policy formulation. So do the increasing, and in my mind well-justified, concerns with the problem of inflation by the national administration and by the citizenry. (Volcker, 1978, pp. 61-62)

Throughout the first half of 1979, Volcker was part of a vocal minority on the FOMC noting that the inflationary situation was approaching crisis proportions. But agonizing fears of recession kept the majority in Chairman Millers FOMC from tightening policy to the extent necessary to contain inflation. President Carters nomination of Paul Volcker to be Chairman of the Federal Reserve in late July started to shift this balance. But by late September 1979, the FOMC came to face the underlying crisis that Paul Volcker had worried aloud about since the first FOMC meeting of the year: mounting inflationary momentum and accompanying heightened inflation expectations. In addition, a policy crisis had recently emerged as well, whose proximate trigger was the reaction in the media and commodity markets to the four-to-three split of the Board of Governors in its discount rate vote on September 18. Prior to that vote but after his nomination as Chairman on July 25, Volcker had been portrayed in the media as an invincible general leading the war against inflation. By contrast, in its reporting on the discount-rate vote, the media pictured Volcker as a general whose troops, if not deserting, were in major retreat. Jumps in commodity prices also revealed that the FOMC had lost credibility regarding its commitment to an anti-inflationary policy.

A "strategic plan" was required that would restore the public's faith in the FOMC and contain "inflationary psychology." It had become clear to the FOMC that the "plan" had to be made public, break dramatically with established practice, allow for the possibility of substantial increases in short-term interest rates, yet be politically acceptable, and convince financial market participants and people more generally that it would succeed. The new operating procedures, focusing on using nonborrowed reserves to keep monetary growth within the announced ranges for the year, satisfied these conditions. The available record does not suggest that the FOMC was converted to monetarist ideology. The "monetarist experiment" of October 1979 was not really monetarist! Rather, the new techniques were conditionally adopted for pragmatic reasons--there was a good chance that they would succeed in restoring stability. In essence, the Committee accepted that, under the prevailing circumstances, controlling monetary growth presented a robust approach to taming inflation. The "plan," while undoubtedly not perfect, turned out to be pretty good. It accomplished its major objectives of reversing rising inflationary expectations and taking the crucial initial steps in a two-decade-long journey back to price stability. And, perhaps as important, it instilled a focus on controlling inflation and inflationary expectations as an enduring aspect of Federal Reserve monetary strategy. ?


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Tinsley, P.A.; von zur Muehlen, P. and Fries, G. "The Short-Run Volatility of Money Stock Targeting." Journal of Monetary Economics, September 1982, 10(2), pp. 215-37.

Tobin, James. "On Consequences and Criticisms of Monetary Targeting, or Monetary Targeting: Dead at Last?: Comment." Journal of Money, Credit, and Banking, November 1985,77(4 Part 2), pp. 605-09.

Treaster, Joseph B. Paul Volcker: The Making of a Financial Legend. Hoboken, NJ: John Wiley & Sons, 2004, pp. 61-62.

U.S. Congress Joint Economic Committee. Domestic and International Implications of the Federal Reserve's New Policy Actions. Hearings before the Subcommittee on International International, November 5,1979. Washington, DC: Government Printing Office, 1980.

U.S. House of Representatives. "The New Federal Reserve Technical Procedures for Controlling Money," in Measurement and Control of the Money Supply. Hearings before the Subcommittee on Domestic Monetary Policy, March 20 & 25, 1980. Washington, DC: Government Printing Office, 1980a.

U.S. House of Representatives. Conduct of Monetary Policy. Transcript. Committee on Banking, Finance and Urban Affairs. Washington, DC: Government Printing Office, February 18,1980b.

U.S. House of Representatives. "Monetary Policy for 1980."Third Report by the Committee on Banking, Finance and Urban Affairs. House Report No. 96-881. Washington, DC: Government Printing Office, April 15,1980c.

U.S. Senate. Nomination of Paul A. Volcker. Hearings before the Committee on Banking, Housing, and Urban Affairs.

Washington, DC: Government Printing Office, 1979.

U.S. Senate. "Federal Reserve's First Monetary Policy Report for 1980." Hearings before the Committee on Banking, Housing, and Urban Affairs. Washington, DC: Government Printing Office, February 25,1980.

Volcker, Paul A. "The Contributions and Limitations of 'Monetary' Analysis." Remarks before the American Economic Association and the American Finance Association, September 16,1976 (reprinted in Federal Reserve Bank of New York Monthly Review, October 1976).

Volcker, Paul A. The Rediscovery of the Business Cycle. London: Free Press, 1978.

Volcker, Paul A. "A Time of Testing." Remarks before the American Bankers Association, October 9, 1979a.

Volcker, Paul A. Statement. Joint Economic Committee, U.S. Congress. Washington, DC: Government Printing Office, October 17,1979b.

Volcker, Paul A. Remarks before the National Press Club, January 2,1980a.

Volcker, Paul A. Prepared statement. Hearings before the Joint Economic Committee, U.S. Congress. Washington, DC: Government Printing Office, February 1,1980b.

Volcker, Paul A. Statement. Committee on Banking, Housing, and Urban Affairs, U.S. Senate. Washington, DC: Government Printing Office, February 4,1980c.

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Volcker, Paul A. Remarks, "Economic Outlook for the 80s." January 15,1980 (reprinted in Texas Business Executive, Summer 1980e).

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(1) Volcker (1978, p. 61).

(2) For a description of the operating procedures prior to the reforms, see Wallich and Keir (1979). See Axilrod (1981) and Lindsey (1986) for descriptions of the new operating procedures.

(3) Governor Partee served on the senior staff of the Board of Governors for many years before his appointment to the Board, which began January 5,1976. The terms of members of the Board expire on January 31 of even-numbered years.

(4) See Kichline (1979a,b,c).

(5) Light editing that actually appears in the official transcripts is shown herewith brackets, []. Further editing we have done for this paper is shown with braces, {}.

(6) In addition to Chairman Volcker, the three previous Federal Reserve Chairmen were at the Belgrade meeting. Chairman Miller was attending as Treasury secretary. And Chairman Martin was to introduce Chairman Burns, who was giving the Per Jacobsson lecture that year. Burns took the occasion to deliver his remarkable "The Anguish of Central Banking," which we return to later on.

(7) While he expressed some doubt as to whether the Federal Reserve would follow through with the program, Greenspan was certainly supportive. Indeed, in congressional testimony on November 5,1979, he strongly defended the Federal Reserve:"! thus conclude that for the United States there is little leeway for policy maneuvering in the monetary area and that the focus, as it should have been all along, must be on defusing underlying inflationary pressures ... 1980 is likely to be a recession year and high interest rates are unquestionably going to exaggerate and prolong any recession. It would be a mistake, however, to attribute the interest rate increases to the Federal Reserve. Its options are limited. The problems reflect earlier inflationary policies. Unless and until we can reverse them, a restoration of balance in our economy will remain illusive"(U.S. Congress Joint Economic Committee, 1980, pp. 7-8).

(8) This figure is reproduced from Lindsey (1986, p. 177, Exhibit 5-1).

(9) See, for example, Johannes and Rasche (1979,1980,1981).Table 1 in the 1981 paper translates the "New Federal Reserve Technical Procedures for Controlling Money" into the money multiplier framework used by monetarists.

(10) See, for example, the studies in Taylor (1999).

(11) Potential output is from the Council of Economic Advisers (1979, p. 75).This estimate, which was prepared in February 1979, was also employed by the Federal Reserve Board staff as its estimate throughout 1979.

(12) The SOMC meeting was on Sunday, February 3,1980, so the members of the committee were not aware of the attachment to Volcker's February 1 Joint Economic Committee testimony.

(13) Tinsley, vonzur Muehlen, and Fries (1982); Lindsey et al. (1984).

(14) See Lindsey (1983).

(15) See Bernanke et al. (1999).

(16) Early in the preparation process for this speech, he even more jocularly suggested the following title: "What Economists Don't Know--That Can Hurt You!" (David Lindsey's recollection.)

(17) At the January 1980 FOMC meeting, President Roos asked about heightening market knowledge and "dynamism" by releasing the reserve paths publicly. Peter Sternlight replied that intermeeting adjustments to those paths would only sow confusion if the quantitative process were carried out in public. He said, though, that more explanation of the "general methodology" would be warranted (FOMC, Transcript, 1/8-9/1980, pp. 9-10).

This article first appeared in the March/April 2005 issue of Review.

Federal Reserve Bank of St. Louis Review, November/December 2013, 95(6), pp. 487-541.

At the time this article was written, David E. Lindsey was a former deputy director of the Division of Monetary Affairs at the Board of Governors of the Federal Reserve System. Athanasios Orphanides was an adviser in the Division of Monetary Affairs at the Board of Governors of the Federal Reserve System, a research fellow of the Centre for Economic Policy Research, and a fellow of the Center for Financial Studies. Robert H. Rasche was senior vice president and director of research at the Federal Reserve Bank of St. Louis. The authors had thanked Steve Axilrod, Norm Bernard, Carl Christ, Ed Ettin, and Allan Meltzer for comments and Stephen Gardner, April Gifford, and Katrina Stierholz for research assistance.

This article has been reformatted since its original publication in Review. Lindsey, David E.; Orphanides, Athanasios and Rasche, Robert H.

"The Reform of October 1979: How It Happened and Why." Federal Reserve Bank of St. Louis Review, March/April 2005,87(2, Part 2), pp. 187-235;
Table 1
October 12, 1979 1-8
(Seasonally adjusted)

                                                   Latest Data

                                          Period    Date      Data

Civilian labor force                      Sept.    10-5-79    103.5
  Unemployment rate (Z) (1/)              Sept.    10-5-79      5.8
  Insured unemployment rate (Z) (1/)      Sept.    10-5-79      3.0
Nonfarm employment, payroll (mile)        Sept.    10-5-79     89.9
  Manufacturing                           Sept.    10-5-79     21.0
  Nonmanufacturing                        Sept.    10-5-79     68.9
Private nonfarm:
  Average weekly hours (hr.) (1/)         Sept.    10-5-79     35.6
  Hourly earnings ($) (1/)                Sept.    10-5-79     6.25
  Average weekly hours (hr#) (1/)         Sept.    10-5-79     40.0
  Unit labor coat (1967-100)              Aug.     9-28-79    176.5
Industrial production (1967-100)          Aug.     9-1A-79    150.9
  Consumer goods                          Aug.     9-14-79    147.7
  Business equipment                      Aug.     9-14-79    170.3
  Defense 6 space equipment               Aug.     9-14-79     92.9
  Materials                               Aug.     9-14-79    155.3
Consumer prices all items (1967-100)      Aug.     9-25-79    220.7
  All items, excluding food & energy      Aug.     9-25-79    209.4
  Food                                    Aug.     9-25-79    235.0
Producer prices: (1967-100)
  Finished goods                          Sept.    10-4-79    221.0
  Intermediate materials, nonfood         Sept.    10-4-79    251.5
  Crude foodstuffs & feedstuffs           Sept.    10-4-79    249.9
Personal income ($ bll.) (2/)             Aug.     9-18-79   1938.1

Mfrs. new orders dur. goods ($ bll.)      Aug.     10-3-79     74.6
  Capital goods industries                Aug.     10-3-79     24.5
    Nondefense                            Aug.     10-3-79     21.5
    Defense                               Aug.     10-3-79      3.0
Inventories to sales ratio: (1/)
  Manufacturing and trade, total          July     10-3-79     1.44
    Manufacturing                         Aug.     10-3-79     1.54
    Trade                                 July     10-3-79     1.34
Ratio: Mfrs.' durable goods inventories
  to unfilled orders (1/) Aug.                     10-3-79     .563
Retail sales, total ($ bil.)              Aug.     9-10-79     72.8
  GAF (3/)                                Aug.     9-10-79     16.1
Auto sales, total (mil. units.) (2/)      Sept.    10-3-79     10.7
  Domestic models                         Sept.    10-3-79      8.5
  Foreign models                          Sept.    10-3-79      2.2
Housing starts, private (thous.) (2/)     Aug.     9-19-79    1,783
Leading Indicators (1967=100)             Aug.     9-28-79    139.1

                                          Percent Change from

                                          Preceding   Periods    Tear
                                           Period     Earlier   earlier

                                                      (At annual rate)

Civilian labor force                           5.2       3.8       2.5
  Unemployment rate (Z) (1/)                   6.0       5.6       5.9
  Insured unemployment rate (Z) (1/)           3.1       2.8       3.4
Nonfarm employment, payroll (mile)             1.8       1.0       3.2
  Manufacturing                                1.4      -1.5       2.3
  Nonmanufacturing                             1.9       1.8       3.5
Private nonfarm:
  Average weekly hours (hr.) (1/)             35.6      35.6      35.8
  Hourly earnings ($) (1/)                    6.22      6.13      5.78
  Average weekly hours (hr#) (1/)             40.1      40.1      40.5
  Unit labor coat (1967-100)                   8.9       7.4       8.2
Industrial production (1967-100)             -13.4      -3.9       2.0
  Consumer goods                             -25.4     -11.3      -1.9
  Business equipment                          -9.1      -2.6       4.2
  Defense 6 space equipment                    6.5       1.7       5.7
  Materials                                  -12.2      -1.0       3.4
Consumer prices all items (1967-100)          12.6      12.1      11*7
  All items, excluding food & energy          12.2      10.4       9.9
  Food                                          .0       1.2       9.5
Producer prices: (1967-100)
  Finished goods                              17.1      14.8      11.8
  Intermediate materials, nonfood             18.4      18.5      14.8
  Crude foodstuffs & feedstuffs               17.5      13.2      13.8
Personal income ($ bll.) (2/)                  5.2       9.8      11.3
                                                (Not at annual rates)
Mfrs. new orders dur. goods ($ bll.)           2.9      -3.2       5.6
  Capital goods industries                     8.6       -.4      13.5
    Nondefense                                 6.1       2.4      16.9
    Defense                                   30.8     -16.7      -6.3
Inventories to sales ratio: (1/)
  Manufacturing and trade, total              1.43      1.44      1.44
    Manufacturing                             1.54      1.48      1.51
    Trade                                     1.33      1.33      1.33
Ratio: Mfrs.' durable goods inventories
  to unfilled orders (1/) Aug.                .557      .546      .600
Retail sales, total ($ bil.)                    .7       1.2       8.1
  GAF (3/)                                      .7       2.7       9.0
Auto sales, total (mil. units.) (2/)          -2.4      12.3        .9
  Domestic models                             -2.6      19.2      -1.9
  Foreign models                              -1.7      -8.3      13.7
Housing starts, private (thous.) (2/)          -.4      -2.8     -11.0
Leading Indicators (1967=100)                   .0       -.5      -2.0

(1/) Actual data used In lieu of percent changes for earlier periods.

(2/) At annual rate.

(3/) Excludes mail order houses.

SOURCE: October 12, 1979, Greenbook.
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Author:Lindsey, David E.; Orphanides, Athanasios; Rasche, Robert H.
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Date:Nov 1, 2013
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