Paul A. Volcker Address on Future Challenges

And now, a word from a distinguished central banker:

Monetary Policy Transmission:  Past and Future Challenges
Distinguished Address by Paul A. Volcker
To Conference on Financial Innovation and Monetary Transmission
Sponsored by the Federal Reserve Bank of New York, April 2002

The subject of this conference — innovation and monetary policy transmission — is something that has naturally concerned me over the years. Historically, the issue has appeared in somewhat different guises. I never thought I had really adequate answers, but somehow the system has worked. Moreover, I am afraid that as far as current technological and financial innovations go, I should be listening rather than speaking. I am not a big user of new technologies. My main experience with technology as president of this Bank and then as chairman of the Federal Reserve Board was asking why staff needed new computers every four years. I always had the feeling that capacity was expanding exponentially over time, but I did not know that monetary policy was becoming any better.

Nonetheless, I believe you are onto an intriguing subject. Indeed, some of the topics covered in your papers remind me of questions I have thought about before. For example, when I was here and when I was in Washington in the late 1970s and early 1980s, we embarked on some new approaches to monetary policy that depended upon control of money by the means of quantitative control of the reserve base.

Hat tip: Money: What it is and how it works

I can remember tossing and turning at night thinking whatever we do,
the banks will try to game us. Could they use the same reserves to
satisfy our reserve requirements at the end of the day and satisfy the
reserve requirements in Asia and in England? Would the result be an
inability to control the effective money supply through U.S. reserve
policy? I see from one of your papers that the issue of how
globalization may affect policy transmission has not gone away, so I
guess my sleepless nights were not entirely misguided.

In preparing for this talk, I read two earlier papers on the topic
of innovation and monetary policy, one by Ben Friedman and the other by
Mike Woodford. They are both intriguing and reassuring in two respects:
First, I am not the only person worrying about the subject of monetary
control, and second, while the technical details may be different, the
underlying concerns of how to conduct monetary policy in the face of
innovations have not changed that much. So rather than trying to look
too far into the future, I thought it might be useful to talk about my
own experiences in previous periods of structural change and innovation
during my career at the Federal Reserve.

I literally have been around the Federal Reserve for more than fifty
years. I wrote my senior thesis on Federal Reserve policy in 1949. From
then until at least the last few years, I have been more or less
directly involved with the Fed. I have always liked one piece of
philosophy by Yogi Berra. He said you can observe quite a lot just by
watching, and I have done quite a lot of watching of the Federal
Reserve. So it might be of some passing interest to share the
observations I have made over a period of fifty years. And if nothing
else, it will give you some reassurance that the kinds of problems you
are worried about are not exactly new, although they certainly come in
different packages.

I remember when I wrote my thesis that the historic, never fully
resolved intellectual argument over central banking was between the
so-called currency school and the banking school with its real-bills
doctrine. Those schools of thought have gone through several
permutations and combinations since, but the substance of the argument
remains the same: Is it money or credit that is important? I would also
tell you that fifty years ago, I remember very well, there was a lot of
concern about the effectiveness of monetary policy.

At the time, the United States had just finished going through the
long depression of the 1930s, which, from the standpoint of monetary
policy, was somewhat similar to the experience in Japan now. There was
the perception of a liquidity trap. There was a real question whether,
under the circumstances, monetary policy was worth worrying about. lt
seemed helpless. Fiscal policy was the king of the day and that carried
over into the postwar period when interest rates were frozen. I
remember well that the New York Fed struggled with that problem when I
was a young fellow here. (Actually, my conclusion in my college thesis,
which I had forgotten about until some student reminded me later, was
that monetary policy was so impotent that we ought to just let the
Treasury handle it.)

Back then there was very heavy political pressure to keep interest
rates stable, and that was the driving responsibility Federal Reserve
for many years — not just during World II, but after. By the time I
had actually arrived here in 1951, the so-called Treasury/Federal
Reserve Accord allowed the Federal Reserve to move interest rates
freely. But the Fed was not about to move them very far.

The idea that was promoted by this particular institution at the
time was something called the availability doctrine.  Bob Roosa, a name
that may resonate with some of you, was the key economist here and an
ingenious analyst of monetary policy.  He developed the idea that
interest rates did not need to move very much to be effective; it would
in fact be dangerous to move them very much because of the heavy,
excessive of overhang government securities in the hands of the banks,
most of which was fairly long-term debt. He proposed that the Federal
Reserve could take advantage of the situation by implementing a very
small increase in interest rates, which, as we all learned in Economics
101, would push down the prices of assets on bank balance sheets. That
would so disturb the banks that they would refuse to liquidate any
securities because they would not want to report losses. Therefore,
they would have to restrain their lending activity. And that would be
the mechanism by which Federal Reserve policy would be effective.

The mechanism obviously relied upon a market imperfection, which I
do not think was totally unrealistic at the time, but it was not
lasting. At the end of World War II, banks were loaded with government
securities and there was a big question of how they would react to even
a relatively small decline in the securities’ value.

I should point out that during the same period, we did not just
think about monetary policy and fiscal policy.  It was monetary policy,
fiscal policy, and debt management.  As unlikely as it sounds today,
debt management was considered to be an active “third leg’ of policy.
In 1953, the Treasury got aggressive and issued some 30 year bonds –
the “3.25s of 78-83.”  The Treasury market was somewhat disturbed, and
the economy went into a recession.  Whether the Treasury’s aggressive
debt issuance was a contributing factor was much discussed, and a long
argument ensued about whether the Federal Reserve should intervene
directly by conducting open market operations in the long-term market
or whether such intervention should be left to debt management, with
the Fed operating with “bills only.”  While we all know how that
discussion ended, the debate at the time clearly centered on whether
monetary policy could be effective independent of debt management.

In the 1960s I moved from the Federal Reserve to the Treasury
Department.  At the time, we faced what was perceived as a dilemma for
debt management and monetary policy.  We had a trade surplus, but the
balance-of-payments deficit probably ran as much as $2 billion or $3
billion a year.  This was a matter of some considerable concern around
the world, since it raised questions about whether our low interest
rates and capital outflow would determine the role of the dollar in the
world economy.  Bob Roosa had preceded me in moving from the Federal
Reserve to become Under Secretary of the Treasury for Monetary
Affairs.  In response to this situation, he helped develop what was
called Operation Twist: the Treasury would retire long-term securities
and issue short-term securities based on the theory that it was the
short-term rate that was relevant for international capital flows,
while long-term rates were more relevant for the domestic economy,
mainly because they affected the mortgage rate.

Well, to the extent that Operation Twist worked at all – and I must
confess I was a little skeptical about it, given the fluidity of the
markets even then – it too depended on some degree of market
imperfection. And I think it became apparent fairly quickly that the
market imperfection was not as great as had been assumed.

Instead, a quite different imperfection was imposed on the market,
and it was not ineffective at all. Regulation Q, which placed a ceiling
on commercial bank interest rates, became in practice the “hammer” of
Federal Reserve policy.  The restraints on interest rates that banks
could pay may have dropped from recent memory, but suffice it to say
that Reg Q’s major components were that 1) interest on demand deposits
was not permitted and 2) there was a hard ceiling on interest rates on
time deposits of all types, including savings deposits. Furthermore,
commercial banks’ liabilities were the dominant financial savings
instrument at the time.   When interest rates went up and impinged on
the interest rate ceilings, the commercial banks could not raise
money.  They pulled back on lending, particularly mortgage lending.

Reg Q worked with extreme force, I think it is fair to say. When
interest rates rose above the ceilings, you had a recession, and the
recession was concentrated in the housing sector. Reg Q therefore
became a matter of political concerned as well as economic concern
because of the concentration of its impact.

By the time we got to the late 1970s and early 1980s, inflation had
picked up a lot of steam and was pushing interest rates progressively
higher. Restiveness about the Reg Q structure came to a head and the
interest rate ceilings were gradually removed.  In fact, the
effectiveness of Reg Q was partly removed by the actions of banks
themselves in developing other techniques for raising money.

So by the late 1970s, we felt that if we wanted to control
inflationary pressures, we were left with having to follow the advice
of Anna Schwartz and others: we should carefully control reserve
growth, which, via open market operations and the fulcrum of reserve
requirements, should limit the expansion of bank deposits and credit.
Whether or not one believed in the strict interpretation of the
“monetarist” theories, the operational relationship between reserves
and money, however measured, was direct.  Controlling reserve growth
was one way to slow money growth and get some restraining influence on
the economy. And I think it is fair to say that eventually we did get a
restraining influence.

The problem of course is that it took a very high level of interest
rates to get that restraining influence. Al Wojnilower, who was
observing all this from the outside, was one of the first to point this
out, and he turned out to be absolutely right. I do not think that any
of us embarking on this policy felt we were going to end up with bank
lending rates at 21 percent in the United States. I think that happened
because people dependent on bank lending did not follow a nice
conceptual textbook approach and say, “the interest rate is a little
higher, so we’ll pull back a little bit.” They were caught up in
ongoing operations; they were caught up in planned investment programs;
they were caught up in their habitual methods of operation. So they
kept borrowing and implicitly thinking “well, this interest rate is
awfully high today, but maybe it will come down tomorrow, so we’ll keep
at it.” And the credit expansion continued until, to exaggerate a
little bit, this became a policy of restraint by bankruptcy.  If you
keep tightening policy until borrowers and lenders really cannot stand
it anymore, you begin to have a real degree of restraint on the economy
and on prices. And indeed, we had a real degree of restraint, and
inflation came down.

The economy was affected by direct controls as well. I neglected to
mention earlier that direct controls on credit extensions were a
favored instrument of monetary policy in the late 1940s and 1950s. When
I wrote my untitled, uncompleted thesis for my Ph.D. (which I
understand I am still eligible to receive if I ever complete the
thesis), I contrasted the use of direct controls on credit in the
United Kingdom with direct control in the United States and how they
operated (or did not) in a market system. But I do not want to gloss
over the fact that we had a little experiment with direct controls as
late as 1980 during the Carter administration. We designed what we
thought was a modest, market-mimicking restraint on some parts of
consumer credit. This was something we anticipated would have a modest
restraining effect on the economy, supplementing our control over
reserves. It turned out to have a huge psychological effect. I never
saw anything like it. There was a sharp reaction by consumers that
single-handedly drove the economy into recession in a matter of weeks.
I believe that was the last time there was any experimentation in
direct control of credit.

Since the early 1980s, I think it is fair to say that we have
returned to a kind of approach that relies upon direct influence on the
short-term rate and a much more fluid market situation that allows
policy to be transmitted through the markets by some mysterious or
maybe not so mysterious process. I think we have found two important
“transmission belts” – domestic asset prices (particularly the stock
market) and the exchange rate – that were not considered to have much
importance earlier. I think we also know that relationships between
monetary policy and stock prices and between monetary policy and
exchange rates are not the most predictable relationships that exist in
the economy. We have certainly seen demonstrations of that recently. I
was a little bit bemused by the reports in the press recently that the
euro declined because the European Central Bank did not reduce interest
rates, which is not what you consider the normal predictable reaction
to monetary policy.

I think this caution helps demonstrate the importance of central
banks having a clear and unambiguous decision making process when they
operate in much more open and fluid markets, if market responses are to
be predictable. Indeed you sometimes might ask the question whether the
Federal Reserve is driving asset prices and the exchange rate or
whether the exchange rate and asset prices are driving the Federal
Reserve. That is an uncomfortable question to ask when you are trying
to run a central bank.

So now we look ahead and the markets are getting ever more fluid and
flexible.  We have several papers here today asking what is the result
of running the world on fewer and fewer reserves (which in the United
we apparently no longer try to control anyway).  Moreover the
commercial banking system and bank deposits are getting progressively
smaller as a part of the financial system.

So what happens?  From my recitation of this history, I think it
seems clear that both the market and the political system will always
try to game the Federal Reserve and find ways of getting around
restraint. Nobody likes restraint. Everybody likes the stock market to
go up forever and the economy to go up forever. When the central bank
tries to restrain, the natural instinct is to find some way around it,
to find substitutes and new political instruments less directly under
central bank influence. If they cannot find the way economically, they
will look for it politically, which presents another problem. It is
also very clear from history that whatever changes in procedures and
policy were made today will cause changes in the market system
tomorrow, as the market adapts to what you have done and tries to find
a way around it.

Despite those efforts and those changes, a simple observation
suggests that monetary policy is still pretty potent. In fact, the
1990s, as you all know, have been regarded as the great glory days of
monetary policy. There is a sense of conviction in the market that we
can press a few monetary buttons and everything will be solved.

Of course, that is an illusion. The most recent events have
undermined that impression to some degree. Nonetheless, monetary policy
here, and to some degree elsewhere, has achieved an almost mystical
status. You wonder whether it has any real substance at all, or whether
it is all shadow.

I am reminded of the comment by Denis Robertson, a well-known
economist of the 1930s, when he described some monetary phenomena by
referring to the story of the Cheshire cat in Alice and Wonderland. The
cat disappeared, and all you were left with was the grin, but the grin
was that was necessary.

I think the reference is entirely fitting because you have to wonder
whether anything more is necessary these days than a pronouncement that
the Federal Reserve would like to change the federal funds rate by x
percent. The Fed does not actually have to do anything. The rate will
immediately change by x percent.

Will it stay there or not? Well, I think the market is still
dependent upon some action by the Federal Reserve. Sooner or later,
there has to be some intervention. But I think this is a basic question
that we are grappling with at this conference, and one that I believe
we will continue to debate for some time.

When I think about what the central bank ultimately controls, I am
led to thinking about what function of the central bank cannot and will
not be taken over by the other operators in the financial markets,
either individually or collectively. Market participants certainly sit
around ingeniously thinking of how to intermediate and satisfy every
possible demand for liquidity and credit at the lowest possible cost.
So it seems to me – and I say this with some tentativeness – that the
market is going to try to minimize the use of base money, the one thing
the Fed controls. If no interest is paid on base money, market
participants will try to minimize the need to hold reserves or
currency, or develop other payment systems, once again trying to work
around any constraint set up by the central bank.

So what is left for the central bank to control? I think the market
is still a long way from doing away with currency or reserves as a
means of interbank payments. At the end of the day, it is only the
central bank as an institution that can satisfy our demand for currency
and create or withdraw reserves and therefore provide a sense of
liquidity in the markets. In the extreme case, it can create liquidity
without end, since there will be no question about its credit status.
In most circumstance, that power does give the central bank special
influence, both through its actions and through its potential
influence; markets respect this, and will therefore respond to the
intention of policy.

This seems to me to be the last strand of permanence in central
banking. Of course, influence over liquidity does not provide any
assurance that you will use that influence wisely or that the
transmission belt to the economy is going to be obvious and direct.
Operating monetary policy in open, liquid markets means that the
transmission belt will inevitably be unstable: the market in effect is
competing with you, and the central bank will find it necessary to
adjust. All of the history I have recounted suggests that this will be
a continuing struggle.  A fixed rule cannot solve the problem. I think
that is the lesson of the past fifty years. Those fifty years also
offer some hope that central banks will not be inconsequential, even if
they have to adapt their modi operandi constantly.

I want to leave you with one other thought, which may make some
central banks inconsequential. What is the endgame in all of this, of
open markets: the free flow of capital around the world, a couple of
hundred independent countries, some big, some small? I think the
logical long-term result – extending far beyond my living horizon, but
perhaps not yours – is a world currency. With a world currency, we will
not have a lot of independent central banks. What I have not quite
figured out is what the one remaining central bank will do, what
instrument it will use, and how it will be controlled. But I think that
is the direction in which economic and financial logic guides us.

I suspect there will be a lot of way stations along the road to a
world currency. For example, I am pretty sure we are going to go to
some regional currencies, and we will almost certainly have many fewer
currencies. In such an environment, will we have a few large central
banks centered around big countries and monetary centers, each with
some influence, but with their interrelationships guided, influenced,
and affected by the exchange rate between them? Such a structure leaves
open a lot of questions about the organization of the world economy in
ways unrelated to central banking. Nevertheless I think that if the net
result of that kind of a world is very widely fluctuating exchange
rates between major centers, then it will not be a world conducive to
the kind of multilateral open trading system and political harmony that
we like to associate with the benign leadership of the United States
and its partners during the postwar period.

So I will leave you with that thought, confident that you will not
be able to disprove it to me, in my lifetime anyway. That is the safest
kind of projection to make.