Federal Reserve Board Chairman Paul A. Volcker almost never speaks first at the secret meetings of the Federal Open Market Committee, whose 19 members are responsible for deciding the crucial economic question of how fast the nation's money supply should grow.
So committee members were startled when the chairman, in the depths of the last recession, opened the October, 1982, meeting with what one participant calls a "doom and gloom" warning that another dose of the Fed's tight-money, anti-inflation policy could prolong the worldwide economic downturn for years. At Volcker's urging, committee members set aside the approach they had been following dogmatically for three years and opted for looser purse strings.
'Stairway to Heaven'
The ensuing period of unprecedented economic growth and low inflation reaffirmed the Fed and its chairman as the ultimate priesthood of U.S. economic policy. Enshrined in a Washington headquarters whose sweeping marble entrance has been likened to "the stairway to heaven" and shielded from the political winds that sometimes make the White House and Congress sway like weather vanes, the Fed has taken on an aura of almost mythical wisdom and authority.
Yet some officials now acknowledge that the Fed has been flying by the seat of its pants during recent economic storms, depending less on infallible theory or sage philosophy than on the instincts and hunches of its members, on ad hoc responses to market pressures and, in large measure, on luck.
Moreover, even when it charts a clear course, the Fed's ability to steer the U.S. economy is severely limited by the unwieldy and unpredictable techniques it must rely on to influence the money supply, interest rates and economic activity.
'Made the Right Moves'
"In retrospect, we made the right moves, but at the time we took some big gambles and survived some unexpected shocks," confessed one Fed governor, who asked that he not be identified. "It was a much closer call than most people will ever know. I wonder if we as a society will be as fortunate when the next crisis comes."
As the Delphic oracle of economic policy, the Fed is invested by the public with a special privilege--the right to make far-reaching economic policy decisions in near-total secrecy. In return, it is expected to make necessary but unpleasant choices that might be impossible in the glare of publicity. "The less said the better," said E. Gerald Corrigan, Volcker's closest confidant on the FOMC and the newly appointed president of the New York Federal Reserve Bank.
The public will get a rare glimpse into the Fed on Wednesday when Volcker makes his annual appearance before Congress to outline the Fed's goals for money growth and, more importantly, the course of the overall economy for the coming year. It will be his sixth such presentation since his appointment by President Jimmy Carter in 1979.
It was at that time that Volcker pushed the Fed on its history-making course of choking inflation by rejecting one of the prime liberal pieties of the 1970s: that the ever-higher creep of inflation associated with a loose monetary policy was a tolerable price to pay for reducing unemployment.
Before it was finished, the Fed also had to ignore the conservative nostrums of the 1980s: that the "monetarist" doctrine of keeping the money supply on a slow, steady upward path would guarantee inflation-free growth and that the Fed should seek--as the "supply-siders" recommend--to stabilize the dollar in terms of a commodity like gold.
Just as liberals complained that Volcker's approach subjected the nation to a needlessly destructive recession, dyed-in-the-wool monetarists complained that the Fed chairman never gave their theory a true test because he applied monetary controls too harshly at first, then relaxed them too much.
An 'Eclectic' Approach
Convinced by experience, however, that neither doctrine offered an unfailing guide, the Fed has chosen what its members, in desperation, often refer to as an "eclectic" approach--one in which pragmatism is more highly prized than ideology and personal experience frequently outweighs the reams of sophisticated economic analysis prepared by the Fed's professional staff.
This shift away from established dogma has produced some dramatic changes among the Fed's governors. Lyle Gramley and Charles Partee, once liberal supporters of a generally relaxed monetary policy, are now among those most determined not to give inflation a new lease on life. Conversely, President Reagan's two appointees, Martha Seger and Vice Chairman Preston Martin, worry that the central bank has unnecessarily held back economic growth and are now the key advocates for easing the grip on money supply.
Presiding over it all is Chairman Volcker, who has managed to retain control of the close-knit but constantly shifting Federal Open Market Committee, which meets eight times a year around a huge mahogany table. In part, Volcker does it by keeping everyone guessing about his next move.
'Sensing the Consensus'
"(Volcker) adopted monetarism when it suited his purposes, jettisoned it when it no longer did, then re-invoked it when the need arose again," wrote Cary Reich, editor of Institutional Investor. "Behind the closed doors of the FOMC, he has been a brilliant tactician, letting the debate play itself out, sensing the consensus, then shifting toward it--but rarely letting it override his own instincts and judgment."
As Volcker treks up to Capitol Hill this week to outline the Fed's strategy for the year, he is finding that the central bank is under renewed pressure from the White House to adhere more closely to the monetarist ideal of a slow, steady increase in the money supply.
"On occasion, the rate of money growth has been quite volatile, contributing to instability in interest rates and a decline in economic activity," Reagan wrote early this month in his annual economic report. "The sharp reduction in money growth through mid-1982, for example, undoubtedly added to the length and severity of the 1981-1982 recession. And a similar reduction in money growth in the second half of 1984 contributed to the temporary slowing of economic growth late in the year."
Search for Holy Grail
Given their experience of the last few years, however, most Fed officials are convinced that attempting to conform to Reagan's monetary guideline would be about as fruitful as searching for the Holy Grail.
"A world in which monetary policy can be reduced to a simple rule or two seems very appealing," the New York Fed's Corrigan said. "Unfortunately, we don't live in that kind of world."
To understand why the Fed is wary of the Administration's monetarist prescription, it is important to recognize that the Fed actually exercises no direct control over the money supply, much less over its ultimate goal of non-inflationary economic growth. Instead, it depends on a Rube Goldberg-like chain of transactions that eventually have substantial impact but give it little immediate sway over the timing or the magnitude of a change in the money supply.
Demand for Money
Contrary to popular impression, the Fed does not set the money supply directly, because it cannot determine how much money people choose to hold in their bank accounts. What it can do is inject funds into the banking system or drain them out. That influences interest rates, which in turn influence the public demand for money.
Under Volcker, the Federal Reserve adopted what Stephen Axilrod, the Fed's top monetary staff member, describes as a "watershed" transformation in October, 1979. That was when it dropped its traditional technique of closely controlling short-term fluctuations in interest rates.
During the 1970s, this commitment to avoiding large short-term swings in interest rates had rendered the Fed ineffectual against inflation, in large part because the policy made it politically impossible to push up rates fast enough to rein in excessive borrowing. Consequently, massive borrowing forced record price increases.
A 'Faustian Bargain'
In place of the old system, the Fed accepted what former staff member Ralph Bryant, now a senior fellow at the Brookings Institution, called a "Faustian bargain" with monetarism. While fearful that focusing on the money supply exclusively would curb the central bank's own freedom to maneuver, Fed officials realized that monetarism offered them a useful tool for convincing outsiders that they would check the inflationary spiral regardless of the immediate consequences for interest rates.
"It was a marriage of convenience," a Fed staff member said. "The monetarists never trusted us, and we weren't in love with them either."
The Fed, administering the prescription in even larger doses than monetarists had recommended, squeezed double-digit inflation out of the economy, but at the price of the deepest recession since World War II. After three years of following the tight-money policy, the Fed found itself in a monetary straitjacket by late 1982.
When the FOMC met in October of that year, inflation was rapidly unwinding but interest rates remained extraordinarily high, and there was no end in sight to the recession. The announcement by Mexico in August that it could not meet its debt obligations to banks in the United States and other countries threatened to make the economic downturn even worse. At the same time, the Fed's most important money target--M-1, a measure of funds held in currency, checking accounts and travelers' checks--had been growing fast for at least two months and was expected to swell even more in the coming months.
A dilemma faced the Fed: How could it ease up on the economic brakes when its own monetary speedometer was supposedly telling it that it was already going too fast?
"We had very high interest rates, a weak economy, a very fragile international situation--everything was pointing to the need for easing," said Edward G. Boehne, president of the Philadelphia Federal Reserve Bank. "But if you looked at the monetary aggregates, they said we should be tightening. Something was very wrong."
M-1 Target Jettisoned
Agreeing that they could no longer afford to follow the monetarist star exclusively and ignore all the other evidence, a 9-3 majority on the FOMC (there are only 12 voting members on the 19-member committee) decided to jettison the Fed's M-1 target. They retained the broader money supply measures, which include funds in savings accounts and money market funds as well as currency and checking accounts, but at such high levels that the constraints on the Fed's efforts to revive the economy were effectively removed.
"If we had stayed with the monetarist doctrine," said Frank Morris, president of the Federal Reserve Bank of Boston and the longest-standing member of the FOMC, "I'm convinced we could have generated a major depression."
At the time, Volcker publicly dismissed the Fed's turnaround as simply "a small, technical change." But it paved the way for such a strong economic boom that only seven months later Volcker urged the FOMC at its meeting of May, 1983, to tighten monetary policy modestly and restore a target for M-1 growth. Those steps, unprecedented at such an early stage in the recovery, would demonstrate the Fed's anti-inflationary resolve, Volcker maintained, and prevent a revival of inflationary expectations.
Despite the Fed's image as a monolithic decision-maker, the debate at the May meeting grew so contentious that it threatened to split the 12 voting members of the FOMC down the middle. Anthony Solomon, then the president of the New York Fed and usually one of Volcker's strongest backers on the committee, won wide support for his opposing argument that any immediate monetary restraint--because it would push up interest rates--might be the "last straw" for Third World nations still groaning under the weight of burdensome debt payments.
Henry Wallich, the last member to vote, could have created an unprecedented deadlock by voting with Solomon. Instead, he sided with Volcker, giving him a bare 7-5 majority.
"Any reasonable person would feel torn in that situation," Wallich said recently. "But a deadlock would have been bad for the chairman and it would have been bad for the institution. That's what finally swayed me."
Later that year, personal attitudes again played a role when the Reagan Administration pressed the Fed to ease its monetary restraint so that the economy would perform strongly during the coming election year. Economic statistics collected by the Fed staff forecast a slowing economy, but several regional Federal Reserve presidents--including Corrigan and Boehne--said their own meetings with local business executives provided strong anecdotal evidence that the first half of 1984 would turn out much stronger. Their position prevailed, and the FOMC decided to stay the course.
For Vice Chairman Martin, though, the Fed's decision to lean again toward tightness was too much. For the first time in his two years on the board, he dissented from the majority in favor of a more relaxed monetary stance, even going so far as to publicize his dissent by sending minutes of the meeting to newspaper reporters.
Martin's actions raised speculation, which he denied, that he had finally decided to dissent because he was disappointed about not being appointed Fed chairman during the summer, when President Reagan chose to reappoint Volcker to a new four-year term.
Tapping Monetary Brakes
As it turned out, the Fed's tapping of the monetary brakes did not prevent the economy from booming in the first half of the year. Martin again objected at the next FOMC meeting to the Fed's tightness, which contributed to a rise in interest rates during the spring, and his dissents won plaudits from such supply-siders as Rep. Jack Kemp (R-N.Y.), who believes that the Fed has been far more restrictive than necessary.
"I don't think we have an overheated economy," Martin said in a speech at the time. "I think we have some overheated economists."
Kemp, who is widely considered a major presidential contender for 1988, has long objected to the Fed's insularity, contending that it is time to "democratize" the central bank. During the Republican convention in August, he won support for a plank in the platform accusing the Fed of "destabilizing actions" and suggesting that a "gold standard may be a useful mechanism."
"The value of the currency," Kemp said recently, "cannot be allowed to change according to the personal judgments of any one individual, no matter how wise he may be."
The Fed's independence also worries many Reagan Administration officials--as it has officials of previous Administrations. They point out that several Fed governors and many top staff members have spent their entire careers inside the comfortable offices of the Federal Reserve system.
Much of what the Fed does, one top Treasury official complained, "simply reflects the ingrown instincts of a self-protective bureaucracy jealously guarding its own prerogatives."
The Fed's defenders, though, insist that the shield around the Fed is necessary to insulate its decisions as much as possible from short-term political considerations. They argue that Volcker's aloof vagueness, often couched in statements that are no clearer than the smoke from his ever-present cigar, has helped the Fed sustain its battle against inflation long enough to win back its lost credibility on Wall Street.
"As a practical matter, the Fed could not really explain what it has been doing because the political reaction would have been just too fierce," said Robert Holland, a longtime staff member and former Fed governor who is now head of the nonpartisan Committee for Economic Development. "Nobody, even inside the Fed, knew how high interest rates would have to go to break inflation."