FRBSF Economic Letter
2004-35; December 3, 2004
October 6, 1979
Twenty-five
years ago, on October 6, 1979, the Federal Reserve adopted new
policy procedures that led to skyrocketing interest
rates and two back-to-back recessions but that also broke the back
of inflation and ushered in the environment of low inflation and
general economic stability the United States has enjoyed for nearly
two decades. The dramatic policy actions by the Federal Reserve
in 1979 represented an important break with the past, both in the
way monetary policy was conducted and in the importance placed
on controlling inflation. This Economic Letter discusses the context
within which the October 6 decisions were taken, the immediate
consequences of those decisions, and the lessons today's central
bankers have learned from them.
Background
 Figure
1 shows two measures of the rate of inflation from 1964 to 1984—the
consumer price index (CPI) and the "core" CPI,
which excludes the volatile food and energy components. Over the
first fifteen years in the figure, inflation in the United States
ratcheted upwards, averaging 2.6% per year from 1964 to 1968, 5%
from 1969 to 1973, and 8% from 1974 to 1978. Then, in the first
nine months of 1979, average annual inflation jumped to 10.75%.
This dramatic rise was partially due to a new round of oil price
increases. But even the core CPI, which excludes the volatile food
and energy components, averaged a 9.4% annual rate.
Inflation at this high level during peacetime
was unprecedented in American history. And it produced a variety
of policies to tame
it, including President Nixon's wage and price controls, responsible
for some of the temporary decline in inflation in 1971 and 1972,
and President Ford's WIN (for "Whip Inflation Now") buttons,
introduced in 1974.
While inflation was unusually high in 1979,
unemployment was not. The United States had experienced a sharp
recession in 1974 and
1975, with the unemployment rate reaching a peak of 9% in May 1975
and then declining steadily over the next four years. The unemployment
rate averaged 5.8% during the first nine months of 1979. Thus,
entering the fall of 1979, unemployment was slightly above its
average over the previous fifteen years while inflation was at
a troublingly high level.
Policy operating procedures
To understand the significance
of the October 6 policy changes, it is first necessary to review
the procedures the Fed had been
using to implement monetary policy. During the late 1970s, the
Fed implemented policy through procedures that were meant to control
inflation by controlling the growth rate of the money supply. The
basic approach was sensible—economy theory predicts that there
is a close relationship between the average rate of inflation and
the average rate of growth in the money supply. Beginning in 1975,
the Fed was required by Congress to establish target growth rates
for the money supply, to report the targets to Congress, and, if
the targets were not met, to explain why not.
In practice, the Fed's
procedures sent conflicting and confusing signals to the public
about the Fed's desire to control inflation.
Some of the confusion arose because the Fed established target
ranges for several different measures of the money supply, or monetary
aggregates as they were commonly called, without providing a clear
statement about the relative importance of the different targets.
The most important target ranges were those for M1 and M2, but
target growth ranges were also adopted for M3 and bank credit.
At times, one aggregate might be growing faster than consistent
with its targeted range, while another aggregate was growing more
slowly than its targeted range, making it difficult to predict
whether the Fed would tighten to reduce the growth rate of the
rapidly growing aggregate or loosen to accelerate the growth rate
of the lagging one.
Another confusing aspect was the way policy
decisions were expressed in terms of money growth targets and a
desired range for the federal
funds rate, the interest rate in the overnight market for reserves.
In textbook treatments of policies to control the money supply,
the central bank decides on the level of bank reserves consistent
with the targeted money supply. The federal funds interest rate
is then allowed to adjust freely to bring the demand for reserves
in line with the supply of reserves set by the central bank. With
the Federal Open Market Committee (FOMC), the Fed's policymaking
body, setting ranges for both money growth and the funds rate,
it was not clear what would happen if, for example, the monetary
aggregates grew faster than expected. Would the Fed stick to its
interest rate target or would it stick to its money growth target?
Chairman Volcker
Paul Volcker became the 12th Chairman
of the Federal Reserve System on August 6, 1979. He was no newcomer
to the Fed system or to the
FOMC, having held a seat on the FOMC by virtue of his previous
position as President of the Federal Reserve Bank of New York.
At the first FOMC meeting under the new chairman, held on August
14, committee members "expressed great concern about inflation." (For
this and other quoted material below, see Board of Governors of
the Federal Reserve System 1980, various pages.) Yet the FOMC seemed
uncertain about how to address the inflation problem. According
to the Record of Policy Actions of the Federal Open Market Committee, "Some
doubt was expressed (by committee members), moreover, that further
restraint could have a significant effect on inflation….
In the face of clear evidence of weakening in economic activity,
it was observed, the need to balance the objective of containing
the recession with the goal of moderating inflation called for
a steady policy for the time being." When the Fed raised the
discount rate in September after a 4-3 split vote, the press interpreted
the split vote as an indication that the Fed was not going to undertake
further actions to boost interest rates and restrain inflation
(Lindsey et al. 2004). In reaction, commodity markets moved sharply.
Gold and silver prices jumped and became more volatile once the
news of the discount rate vote became public. The dollar fell in
a further sign of inflation concerns.
According to Lindsey et al.,
Volcker returned from the annual IMF meetings in Belgrade in early
October "with his ears still
resonating with strongly stated European recommendations for stern
action to stem severe dollar weakness on exchange markets." Volcker
decided to call a special meeting of the FOMC, a meeting that was
not publicly announced, to be held on Saturday, October 6.
By the
time of the secret October 6 meeting, inflation continued to remain
high, the value of dollar had declined significantly,
and the monetary aggregates continued their rapid growth.
October
6, 1979
Chairman Volcker called the October 6 meeting of
the FOMC to decide on better methods for controlling money, credit
expansion,
and
inflation. After the previous FOMC meeting in September, Volcker
had requested a study of new operating procedures that would place
more emphasis on monetary control and less on the federal funds
rate. The need for better control of money growth was clear in
the third quarter data, which showed M1 had grown at an annual
rate in excess of 9%, compared to the Fed's target growth rate
of 1.5 to 4.5%. M2 had grown at a 12% annual rate in the third
quarter, compared to the Fed's target range of 5 to 8%. According
the Record of Policy Actions (p. 202), at the October 6 meeting, "the
members agreed that the current situation called for additional
measures to restrain growth of the monetary aggregates" and "most
members strongly supported a shift in the conduct of open market
operations to an approach placing emphasis on supplying the volume
of bank reserves estimated to be consistent with the desired rates
of growth in the monetary aggregates." The FOMC's discussion
makes clear that the "principal reason advanced for shifting
to an operating procedure aimed at controlling the supply of bank
reserves more directly was that it would provide greater assurance
that the Committee's objectives for monetary growth could be achieved."
 Associated
with a greater focus on monetary control was a significant widening
of the range for the federal funds rate. At the meeting
in September, a range of 50 basis points, from 11-1/4 to 11-3/4%,
was set for the funds rate; at the October meeting, this range
was increased to 400 basis points, from 11-1/2 to 15-1/2%. In
response to these changes, the funds rate rose sharply, and by
year end
was close to 14% (see Figure 2). The funds rate peaked in April
1980, when it averaged 17.6%.
The rise in interest rates led
to an economic recession that began in January 1980. Unemployment
eventually peaked in August
at 7.8%.
By then, as Figure 2
shows, interest rates had fallen dramatically. This reflected, in part, the
impact of policies announced by President Carter in March 1980
to restrain credit directly.
The Fed instituted new special reserve requirements, a surcharge on some
discount window borrowing, and a program of voluntary credit restraint.
Late in 1980,
interest rates were pushed back up, and the funds rate averaged over 19%
in June 1981. A new recession began in July, one that saw the unemployment
rate reach
almost 11% by the end of 1982. By that time, though, inflation, which had
averaged
14.6% in the year from May 1979 to April 1980, had fallen below 4%. The era
of low inflation had begun.
Lessons
In retrospect, it seems clear that inflation
was the most pressing problem facing monetary policy in early
1979 and that the
Fed needed to act decisively
to reduce
it. The adoption of a tough anti-inflation policy was delayed because
FOMC members were concerned with more than just inflation. Worries
about the
level of real
economic activity and unemployment often seemed to take precedence over
inflation during the early months of 1979. In fact, even
though the CPI rose at a 13%
annual rate during the first quarter of 1979 while unemployment was down
to 5.8% (from
7.1% in 1978), two FOMC members dissented at the May 22 meeting in favor
of easing monetary policy. These members were concerned
that the economy was slowing
and
that unemployment might rise. Attempting to balance multiple objectives
prevented the Fed from concentrating on the problem of bringing
down inflation.
Today, central bankers recognize that maintaining
low inflation is their primary responsibility. While monetary
policy can
also contribute to reducing
overall
economic instability, there is a better understanding that maintaining
low inflation is not inconsistent with overall economic stability but
in fact
is an important
aspect of it. Second, central bankers today understand that monetary
policy works best when the public is convinced that inflation
will remain low
and stable.
The credibility of a low-inflation policy is best maintained in an
environment in which central banks explain their actions and make
their objectives
clear. Central banks are now more likely to distinguish clearly between
instruments,
such as money growth or interest rates, and the ultimate objectives
of policy such as low inflation.
The United States, most other developed
economies, and many developing nations have enjoyed low inflation
during the past twenty years. In
the U.S., the
October 6, 1979, FOMC meeting was a turning point in the battle against
inflation. The lessons learned from that earlier battle continue
to serve monetary policy
well.
Carl E. Walsh
Professor, UC Santa Cruz, and
Visiting Scholar, FRBSF
References
[URL accessed November 2004.]
Board of Governors of the
Federal Reserve System. 1980. 66th Annual Report 1979.
Lindsey, D.E., A. Orphanides, and R.H. Rasche.
2004. "The
Reform of October 1979: How It Happened and Why." Prepared
for the Conference on Reflections on Monetary Policy 25 Years
after October 1979, Federal Reserve Bank of St. Louis, Oct. 2004. http://research.stlouisfed.org/conferences/smallconf/lindsey.pdf
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