|Paul Volker - Part 1
"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, the following are some definitions of terms that may make it easier to understand these 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
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. 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, 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.
"New York Times: Century of Business," Floyd Norris and
"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