“Paul Volcker stands out as one of the great central bankers of
the twentieth century.”
–Economist Henry Kaufman
For the next two weeks we are going to take a look at a giant in
the financial world, the former Federal Reserve Chairman, Paul
Volcker. We will also detour once or twice to examine some of
the players who helped shape the Volcker era.
But first, following are some definitions of terms that may make
it easier to understand the pieces:
Discount Rate: The interest rate charged by the Federal Reserve
on loans to its member banks.
Federal Funds Rate: The rate of interest on overnight loans of
excess reserves among commercial banks.
M1: Measurement of the domestic money supply that
incorporates only money that is ordinarily used for spending on
goods and services. M1 includes currency, checking account
balances, and travelers” checks.
M2: A measure of the money supply that includes M1 plus
savings and time deposits, overnight repurchase agreements, and
personal balances in money market accounts. Thus, M2 includes
money that can be used for spending (M1) plus items that can be
quickly converted to M1.
Money Supply: The amount of money in the economy. Since the
money supply is considered by some to be a critical element in
determining economic activity, from time to time the financial
markets place great importance on the Federal Reserve”s reports
of changes in the supply. For example, consistently large
increases in the money supply can lead to future inflation. [But,
that hasn”t proven to be the case, yet, in analyzing the Wall
Street of the last few years.and today.]
Prime Rate: A short-term interest rate quoted by a commercial
bank as an indication of the rate being charged on loans to its
best commercial customers. While banks frequently charge more
than the quoted ”prime rate,” it is a benchmark against which
other rates are measured.
—
Paul Volcker was a career civil servant and central banker who,
among his various positions, served as Under Secretary of the
Treasury under Richard Nixon and then president of the New
York Federal Reserve Bank.
Volcker was an imposing figure, 6”7″ to be exact, and a major
player on the world financial stage as the year 1979 unwound.
With his broad background, and the international markets in a
state of flux, it was time for him to take the spotlight.
1979 was a bleak year for America. The economic news was not
good: soaring interest rates, inflation, and a rising foreign trade
deficit led to a moribund stock market.
Events overseas were attracting attention, particularly in Iran,
where in January, the Shah had been toppled and a
fundamentalist Islamic dictatorship installed under the rule of
Ayatollah Khomenei. By November, Islamic revolutionaries
seized the U.S. embassy, taking 90 hostages.
It was a time of malaise, the Jimmy Carter era. Optimism was
not in strong supply.
And within the Carter administration, there was a lot of
infighting over the nation”s economic policy. Inflation was to hit
13.3% in 1979. Treasury Secretary Michael Blumenthal
advocated higher interest rates to bring inflation under control.
The Chairman of the Federal Reserve, G. William Miller,
thought monetary policy was just fine and resisted raising rates.
Miller thought that inflation would eventually peter out all by
itself.
In these situations, arguments between the Fed and the
administration are not to be carried out in public. There is a
history of upholding the Fed”s independence and to de-politicize
their role as much as possible. But Blumenthal and Miller took
their differences of opinion outside. They exchanged barbs in
speeches and in publications from about April to July.
Through it all, Wall Street was losing confidence in Miller. The
stock market was in the midst of a long period of mediocrity. In
recovering from the ”73-”74 bear market low of 577 on the Dow
Jones, the market had peaked at 1014 in September of 1976.
From there it was a steady drip, drip down and by the summer of
1979, the market had been trading in the 800”s for months.
[Actually, outside of two days in November, the Dow, as
measured by the closing average, traded in the 800”s all year!]
So on July 19, President Carter decided that it was time to make
a change and Blumenthal was fired (as well as three other cabinet
members, with a fifth resigning) to be replaced at Treasury by
Miller. Then on July 25 Carter nominated Paul Volcker to be the
new chairman of the Federal Reserve. Wall Street celebrated by
rallying 10 points that day, 829 to 839.
Historian Charles Geisst comments:
“Volcker was selected because he was the candidate of Wall
Street. This was their price, in effect. What was known about
him? That he was able and bright and it was also known that he
was conservative. What wasn”t known was that he was going to
impose some very dramatic changes.”
[As I read this passage, I was struck by the similarity with the
process of selecting Supreme Court nominees. Presidents often
think they know where a particular judge stands before they are
selected. But then often the “conservative” becomes a “liberal”
jurist, and vice versa.]
Volcker was confirmed by Congress on August 2 and then sworn
in on August 6. He got to work.
While the U.S. economy was growing, when you took out
inflation the growth was minimal. It was a period of
“stagflation,” inflation with slow to zero growth. As the data
rolled in, Volcker made it clear that inflation was “public enemy
number one.”
On October 4, the September Producer Price Index showed a rise
of 17%, the largest increase in 5 years.
On October 5, the Labor Department said unemployment had
declined slightly to 5.8%.
Meanwhile, the money supply had been expanding rapidly. The
markets grew increasingly skittish. And overseas, investors were
uneasy over the U.S. seeming inability to solve the inflation
problem. The dollar was weak and the trade deficit was soaring.
Volcker commenced an attack on the money supply as soon as he
took control. He began to set a target for the growth of money,
in the hopes that demand for credit would begin to dry up. The
federal funds rate was increased in the hope that banks would
eventually cut back on their loan lending. If it became difficult
to find new capital, company”s expansion plans would be put on
hold.
Then on October 6, Volcker acted even more forcefully.
Holding a rare Saturday night news conference [remember, he
didn”t have to compete with classic episodes of “Who Wants to
be a Millionaire” back then] he unleashed his own version of the
“Saturday Night Massacre.” Pointing to the recent economic
releases, Volcker said, “Business data has been good and better
than expected. Inflation data has been bad and perhaps worse
than expected.”
The Chairman announced that the discount rate was being
increased a full percentage point to a record 12%. “We consider
that (this) action will effectively reinforce actions taken earlier to
deal with the inflationary environment.”
But Volcker wasn”t just looking to slow inflation, he was seeking
to smash it! It was just the start. And the Carter administration
was none too pleased. And neither were the financial markets.
When the Dow Jones opened on Monday, October 8, it fell from
898 to 884. Within a month it would be below 800. [Those two
aforementioned days in November.] Meanwhile, in the bond
pits, rates soared. The 3-month Treasury Bill, yielding around
8% in late September, climbed to 12.5% by year end.
One sidelight to the market maneuverings around the October 6
Fed announcement. On October 5, IBM had brought to market
the largest corporate bond offering ever, $1 billion. Of course,
the fixed income market was roiled that following Monday.
Many of the 225 investment banks in on the deal were left with
large amounts of inventory. [Not having anticipated any
problems, the firms had taken down positions in the IBM bonds
in the full confidence that it would be easy to resell them to their
clients. The sudden rise in rates on Monday, and the
commensurate decline in the value of bonds, meant that some
firms faced large losses on their positions of unsold paper.
Ironically, Salomon, the co-lead in the offering, had sold
virtually all of its bonds before Volcker”s announcement, thus
losing little, which fanned speculation that they had inside
information. This was never proved to be the case.]
We”ll continue the story next week.
Sources:
“New York Times: Century of Business,” Floyd Norris and
Christine Bockelman
“Monopolies in America,” Charles Geisst
“Wall Street: A History,” Charles Geisst
“The Pursuit of Wealth,” Robert Sobel
“On Money and Markets,” Henry Kaufman
“Wall Street Words,” David Scott
Brian Trumbore
