“It”s easy for a central banker to be popular during euphoric
financial times. But the political perils are severe when tough
measures are needed – measures that extract a high short-term
toll in the interest of longer-term economic health – as they were
in the late 1970s.”
–Economist Henry Kaufman
As we pick up our story of former Federal Reserve Chairman
Paul Volcker, it”s the fall of 1979 and Volcker has recently been
named chairman, putting his mark on Fed policy by raising the
discount rate a full percentage point while emphasizing that
killing inflation was his number one priority. Volcker realized
he risked putting the economy into recession.
Interest rates soared. While the 3-month Treasury Bill was
climbing from 8% in September of ”79 to 12.5% by year end, the
Fed wasn”t counting on long-term rates rising as well, from the
9.2% level in September to 10.1% by December 31st. [In most
normal environments, as the Fed is increasing short interest rates
(the only thing they can influence directly), the longer end of the
yield curve responds positively. Since the longer end represents
“inflation expectations,” by raising short rates you would expect
to eventually slow the economy and dampen inflation fears.
Thus, the premium that investors demand for buying longer-term
instruments should narrow, not widen.]
Into early 1980 interest rates across the board continued to rise
and the economy tipped into recession (a mild one but an
important one as far as the presidential election of 1980 was
concerned). By the end of the first quarter, the long bond was
yielding 12.3%. Treasury Bills were to peak that year in the
second quarter, 15.6%. The inflation rate for the first quarter of
1980, as measured by the CPI was 14.6%.
Awful news. But what we didn”t know at the time, as is often
the case during events such as these, was that the back of
inflation had been broken. By the middle of 1981, it was
running at a 9.7% clip and for the year it was below 9%.
Volcker was winning.
But the times were tough on the chairman. Henry Kaufman went
to visit him in 1980 and he observed that construction bricks
were filling an outer office, yet no renovation appeared to be
taking place. It turns out that the Brick Layers Union had sent
them over, along with a note saying that they were no longer
needed. A rather vicious reminder of the troubled economic
environment.
1980 was a miserable year for President Carter as well. Inflation,
unbelievably high interest rates, a desultory stock market, and the
Iranian hostage crisis. Carter went against the policy of the Fed
and instituted his own policy of “special credit controls” whereby
special requirements were placed on the reserves of banks and
credit card companies. Volcker sat by, not wanting to be seen
playing politics. Like the price controls of President Nixon, the
credit controls worked for a spell and rates declined, only to
soar anew.
Reagan won the election that November and, as soon as the votes
were tabulated, Volcker began to tighten interest rates more. The
federal funds rate, which had averaged 11.2% in 1979, peaked at
20% in June 1981. The prime rate rose to 21.5% in ”81 as well.
Treasury Bills hit 17.3% and the long-term bond was on its way
to 15.3%.
Upon taking office, Ronald Reagan said that the country faced
the threat of economic calamity. But many would say his
preferred policies of tax cuts would encourage spending and
investment and thus hamper Volcker”s effort to kill inflation,
once and for all.
Reagan, though, certainly understood the importance of ending
the inflation threat and he was willing to endure a deep recession
to accomplish this. Already, early in 1981 there were reports that
he would be a one-term president. [Of course, that spring John
Hinckley almost had his own say on this view.]
But while Reagan would remark at cabinet meetings, “Why do
we need the Federal Reserve at all?” he let Volcker operate with
little interference. [Incidentally, no one was ever able to answer
Reagan”s question. Another example of his simplistic
brilliance.]
By July 1981 the nation was in recession, and it would be a
long, ugly one. [Economists choose November 1982 as the
month the recession ended.] The manufacturing sector was
decimated plus the combination of high interest rates and an
expensive dollar sharply reduced American exports, particularly
hurting farmers. In 1982 the unemployment rate hit 9.7%.
Reagan didn”t waver. He insisted that if the nation “stayed the
course” it would emerge healthier and more prosperous in the
end.
Meanwhile, Paul Volcker stuck to his own guns, convinced that
firm control of the money supply was the key to a sound economy.
And inflation was heading lower. A CPI that registered 13.3%
for 1979 was to plummet to 3.8% for all of 1982.
The stock market, which had reacted positively to Reagan”s
victory in November 1980 with the Dow Jones closing at 953 on
the first trading day after the election, was to become a victim of
the deep recession of ”81-”82 as well. By the summer of 1982
the Dow would plummet to 776 on August 12. But Volcker was
increasingly convinced that the time was near to reverse course.
And another figure who was about to turn positive was “Dr.
Doom,” economist Henry Kaufman of Salomon Brothers.
Kaufman”s pronouncements on the financial markets were
legendary back in the late ”70s – early ”80s. When Henry spoke,
people listened.
I started my career in the financial services industry working in
the same building where Salomon”s headquarters were. I used to
ride the elevator with Mr. Kaufman as our companies were in the
same elevator bank. He always looked so glum and we felt like
saying, “Hey, nice comment Henry!” as the market tanked after a
particularly negative missive from the Doctor.
But by the summer of 1982 Kaufman was becoming increasingly
convinced that a significant interest rate decline lay ahead. The
recession, financial blockages and intense international
competition augured for a more favorable environment in bond
land, and by inference, the stock market. Kaufman decided to
become bullish.
On August 17 Dr. Doom issued a memo proclaiming the worst
was over. The financial markets went ballistic. The Dow Jones
rallied 38.81 that day (792 to 831) or 4.9%.the largest single-
day rise in the markets history. A near record 93 million shares
changed hands and there were 10 stocks up for every 1 down.
And in the bond pits, short-term rates fell about half a point.in
one day! The Fed cut the discount rate in August and the great
bull market that we are still technically in had commenced.
Ironically, as the Fed relaxed policy, money supply growth
soared. The Reagan budget deficits began to soar as well.
Interest rates were to take another hit to the gut in 1984 as the
yield on the long bond hit 14% but, as the realization was also
sinking in that inflation was not going to return to the levels of
1979-81, rates fell and the great bull market in bonds was under
way.
Paul Volcker stayed on as Fed Chairman until his retirement in
June 1987, to be replaced by current chairman Alan Greenspan.
While Volcker has remained active in the financial arena,
perhaps his highest profile stance since his Fed days was taken
during the Long-Term Capital Management fiasco of 1998.
Volcker questioned the “bailout” of LTCM by the consortium of
investment banks. “Why should the weight of the federal
government be brought to bear to help out a private investor?”
I guess they were just too big to fail, Paul. A nasty precedent.
*The Fed is adamant that they were not involved in the LTCM
bailout and that this was not government interference in the free
markets.
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
“The Presidents,” Henry Graff
Brian Trumbore
