Volcker (25 page)

The alarmist quotes from Henry Kaufman and Anthony Solomon caught Volcker's attention. A week earlier, Volcker had written a note to Kaufman after reading his monetary policy pronouncements in the
New York Times
: “Dear Henry: I never thanked you for writing after [my] appointment, but don't think you have to give all your advice through the newspapers—pick up the phone now and again.”
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Kaufman had clearly not taken his old friend's suggestion, but Volcker would forgive him.

Kaufman and Solomon confirmed the crisis Volcker needed for drastic action.

At the morning FOMC meeting on Tuesday, September 18, before the board conflict erupted into public view, Lawrence Roos, president of the Federal Reserve Bank of St. Louis, prodded Volcker.
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“Well, Paul … maybe I am out of order to raise this now, but couldn't there be a discussion again of whether or not our traditional policy of targeting on interest rates … is appropriate? Shouldn't this be given another look … in view of everything you've said and the less than happy experience that the FOMC has had over the past years in achieving its goals?”

Roos had been urging the FOMC to mend its ways ever since joining the committee in 1976, continuing the monetarist tradition of the St. Louis Fed that had begun with its former president, Darryl Francis. Roos had invoked the mantra “focus on money supply and allow interest rates to find their own way” so often that many members of the FOMC thought his remarks sounded like a recorded announcement. Volcker did not. “My feeling would be that you're not out of order in raising that question … I presume that today, for better or worse, we have to couch our policy in what has become the traditional framework. But I think … we should be exploring it again in the relatively near future. And I would plan to do so.”

The future arrived when the crisis made front-page headlines the following day. Volcker responded by asking FOMC economist Stephen
Axilrod and System Open Market Account manager Peter Sternlight to outline the plan that would revolutionize the Federal Reserve's operating procedures. The two career Federal Reserve employees complemented each other perfectly, and based their report on earlier work done at the Fed. Axilrod provided the research perspective as the FOMC's staff director for monetary and financial policy, and Sternlight provided the practical input as manager of securities transactions in the New York Fed's trading room.

On Thursday, September 27, 1979, the day before Volcker's scheduled departure to Belgrade for a meeting of the International Monetary Fund, he reviewed a confidential three-page memo from Axilrod and Sternlight. A single sentence on the second page of their draft captured the essence of the plan Volcker would present to the FOMC after he returned from Europe: “The Federal Open Market Committee … would seek to hold increases in the monetary base and other reserve aggregates to amounts just sufficient to meet monetary targets and to help restrain growth in bank credit, recognizing that such a procedure could result in wider fluctuations in the shortest term money market [interest] rates.”
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Volcker knew that focusing on the monetary aggregates would turn monetary policy on its head. The so-called aggregates referred to measures such as the money supply (checking accounts plus currency), or total bank reserves, or bank reserves plus currency (called the monetary base), that influenced total spending and inflation. The famous quantity theory of money, which Volcker had studied at Princeton, taught that increases in the money supply meant higher prices and inflation. Modern monetarists, led by Milton Friedman, resurrected the lessons of the quantity theory and urged the Federal Reserve to control money and the related monetary aggregates—hence the name “monetarists.”

Volcker believed that controlling the aggregates could help restrain inflation in the long run, but this strategy would also produce wide fluctuations in interest rates in the short run, disturbing traditionalists on the FOMC. The new plan would be considered a monetarist takeover of the Federal Reserve System, and would create turmoil in credit markets, just as a strategy shift at De Beers, the South African diamond cartel, would cause chaos in diamond prices. During the 1970s both De Beers and the Federal Reserve had operated in similar ways.

The mystique of a diamond comes from its beauty and scarcity, but
neither occurs naturally in nature. Diamond cutters engrave facets into raw stones to make them shine, and De Beers restricts the supply to jewelers to keep engagement rings in precious demand. During much of the twentieth century, the Diamond Trading Company, the marketing arm of De Beers, controlled the world's supply of uncut stones offered to the wholesalers of New York, Antwerp, Tel Aviv, and Bombay (now Mumbai).
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These merchants were invited every five weeks to a so-called sight at 2 Charterhouse Street, the London headquarters of the Diamond Trading Company. Monty Charles, a longtime senior manager of the firm, determined the number and size of uncut stones released each month. His job was to keep prices high and stable so that diamonds were profitable for the company but marketable on Main Street.

Charles consulted with economists and industry analysts employed by De Beers. These experts tracked the world demand for diamonds and the inventory of unsold gems in jewelry store windows, examining trends in income, spending, and celebrity fads that might cause the demand for diamonds to rise or fall. Monty then distributed the uncut stones (with a polite request to the wholesalers for payment) that he judged would keep the price of diamonds firm and steady. He would accommodate an expected jump in the public's demand by releasing more uncut stones from the company's underground vaults, and he would neutralize a drop in demand by withholding the raw material from the market and adding them to inventory.

De Beers was not above the law of supply and demand, but it could manipulate supply to prevent shifts in demand from affecting price. If De Beers had pursued a different strategy, such as rigidly increasing mine production every year, it would have had to allow prices to fluctuate with shifts in demand. For example, if De Beers increased diamond output by 5 percent a year, then diamond prices would rise when demand rose by more than 5 percent and prices would fall if demand rose by less (or actually fell).

Volcker had never visited Tiffany or Cartier, but he understood as well as anyone that the Federal Reserve behaved just like De Beers, except that it controlled a different, but no less desirable, scarce resource: the supply of dollars. Commercial banks are legally required to hold dollars as reserves against checking accounts, and individuals need dollars to pay for things they buy. A $100 bill is worth more than
the paper it is printed on because the Federal Reserve System restricts the available supply, just as the value of a polished diamond exceeds the industrial use of the stone because De Beers restricts supply. Unlike De Beers, however, the Fed controls supply to promote economic activity rather than to make a profit. The New York Fed's trading room in Lower Manhattan serves as the system's control center.

When Volcker became chairman, he had promoted Peter Sternlight to manager of the trading desk at the Federal Reserve Bank of New York, replacing Alan Holmes, who had just retired. Volcker had known Sternlight, a thin man who walked three miles to work each day from his Brooklyn apartment, since they served together on the trading desk in the early 1950s. Sternlight was a technical expert, having remained on the eighth floor of the New York Fed's headquarters on Liberty Street for most of his career.

Peter Sternlight manipulated the supply of dollars available as currency and reserves by buying and selling securities in the government bond market. These so-called open market operations occur quietly, via telephone contact between Sternlight's traders and Treasury securities dealers at commercial banks, rather than on the noisy floor of an organized exchange, where trading sometimes resembles a barroom brawl. But these obscure transactions have a profound impact on the FOMC's target federal funds rate, the overnight interest rate on loans of reserves between banks. When Sternlight sells securities and reduces reserves, for example, commercial banks are caught short of their legal requirement, so they scramble to borrow reserves in the federal funds market. This buying pressure drives up the overnight interest rate.

Peter Sternlight aims his transactions at the federal funds rate specified by the FOMC at the end of each meeting. For example, on September 18 the FOMC wanted a slight increase in the rate, so Sternlight engineered a drop in reserves until he hit the new higher target. He would then add reserves if the rate went up too much and would withdraw reserves if the rate went down, just as Monty Charles adjusted the supply of raw diamonds to keep prices steady.

Volcker recognized that this technical procedure, which had served since the Treasury–Federal Reserve Accord in 1951 to maintain orderly conditions in the money markets, now undermined the Fed's credibility as guardian of the currency. Controlling the federal funds rate by
adding or subtracting reserves meant that the Fed lost control over reserves made available to banks, just as when De Beers varied the amount of diamonds it distributed to keep prices steady.

Monty Charles did not mind the loss of control over his inventory, especially when he was releasing more stones than expected, because that made money for De Beers. But Volcker knew it was a disaster for the Federal Reserve continuously to expand reserves and other monetary aggregates to keep the federal funds rate from rising too quickly. The Fed had done precisely that during much of the 1970s, and the end result had been that banks made more loans and created more deposits than the Federal Reserve had promised. The excessive growth in the monetary aggregates—total bank reserves, the monetary base, and the money supply—had fueled inflation and inflationary expectations, destroying the Fed's credibility.

Volcker and other members of the FOMC had rejected the monetarist approach of focusing on the monetary aggregates and permitting greater fluctuations in interest rates many times before. The committee devoted much of the meeting on March 29, 1976, while Arthur Burns was still chairman, to considering placing more emphasis on aggregate reserve measures. The FOMC rejected the plan, in part, because of opposition by Burns. Volcker flirted with the proposal but then concluded, “Mr. Chairman, … maybe this will make you feel a little better … I think I can … give you categorical assurance of not a monetarist in the group.”
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Burns, a diplomat in victory, responded, “Well, that fills me with deep regret.”

In 1978, Volcker dismissed the tight link between money and prices articulated by the quantity theory and put forth by monetarists to keep inflation under control. “I believe there are in fact a variety of nonmonetary … factors that can affect the rate of inflation in the short—and not so short-run … My own support of the use of monetary ‘targets' does not start from a ‘monetarist' perspective.”
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He based his support for targeting the monetary aggregates, as described in the September 27, 1979, Axilrod-Sternlight memorandum, on the favorable impact on inflationary expectations and central bank credibility, an approach closer to rational expectations
than to mainstream monetarism. “The announcement of the so-called [monetary] growth ranges … sets a general framework for expectations about inflation … This role in stabilizing expectations was once the function of the gold standard, the doctrine of the annually balanced budget, and fixed exchange rates. I view the monetary targeting approach as … a new … comprehensible symbol of responsible policy.”
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He wanted to restore the gold standard without gold.

Volcker's commitment to controlling the aggregates would require a drastic shift for the FOMC: abandoning the “prudent and cautious and gradual” approach to interest rates. He knew that anything less would fail to establish the Fed's credibility. He thought the crisis that had exploded on September 18, 1979, justified the risk, and he would exploit that event to persuade the FOMC to implement an experiment it had thus far resisted. But a visit with his Board of Governors colleague Henry Wallich to discuss the draft memo gave him pause.

Volcker and Wallich had much in common, including a dislike of inflation, an attachment to cigars, and a shared history at the Federal Reserve Bank of New York, where they were attracted to the same woman. Volcker recalls, “Henry stole our coworker, Mabel Brown, and married her before I could catch my breath. Actually, he didn't really steal her. It was no contest whatsoever. I was so self-conscious about my looks and height, and she was so pretty, that I never worked up the courage to ask her out. Henry clearly had more confidence.”
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Henry Wallich still had the confidence to defy Volcker, even though Paul was now the chairman of the board. “It's a pact with the devil,” Wallich said when Volcker dropped by his office to discuss the new procedures.
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Wallich's hatred of inflation resembled a childhood phobia, but he worried more about losing control of interest rates. “The existing methods have the advantage that we know the interest rate and we don't run the risk of the rate going in the wrong direction and creating dollar problems.”
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Volcker shared Wallich's concern about the dollar, but felt that the inflation-fighting credibility of the new operating procedures would win support abroad. He would learn the truth on his way to Belgrade, during a private lecture from his old friend Helmut Schmidt, now the chancellor of West Germany.

Volcker sounded like James Bond during a telephone conference call with the FOMC on Friday, October 5, 1979. He had already stressed the confidential nature of the final Axilrod-Sternlight memorandum they would be discussing at the emergency meeting in Washington the following day. The increased gyrations in interest rates under the new procedures could mean millions in profits or losses for financiers and bankers throughout the world. Volcker also wanted to avoid leaks about the meeting itself. “I think there is a need to come in here as inconspicuously as possible … [and to stay] at diverse hotels … I imagine you do know that the Pope is coming in [to Washington] which may be good cover … [but] it may not be [enough].”
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