Becoming Volcker

Introduction

Paul Volcker was not fully formed as the slayer of dragons when he walked into his post as Fed Chair. It didn’t take long though – couple months, no more – but it also took a big shove from a friend in Belgrade.

Becoming a slayer of dragons

In the post-World War II era, the Treasury began to issue 30-year bonds in 1977, shortly after President Carter took office. The issue was a disaster, the bond lost about half its value in the next few years. The dollar was a mess, the damage done by years of mismanagement by a Fed that was not credible (see Figure 1).

Lou Brien is a graduate of The University of Notre Dame. He has been in the markets since 1983; for context, Paul Volcker was the Fed Chair when he began his career. Since 1999 Lou has been a fixture at DRW Trading.

His business card describes him as the Strategist/Knowledge Manager, a wide open remit that allows him to investigate factors that move the economy and markets.

The steady debasement of the dollar since the end of Bretton Woods regime in the early 1970s was making it very expensive to issue debt. So dire was the situation, because of the dollar, that in 1978 the Treasury issued bonds that were denominated in Deutschmarks and Swiss Francs; they were known as Carter Bonds. Reports say that they did better than the dollar-denominated Treasuries.

This was clearly not a situation that could continue.

“Two months into his new job, Volcker attended a conference of central bankers in Belgrade and was shocked to find himself harangued by his peers,” says an article from the Atlantic magazine from October 2018 called Paul Volcker’s Guide to the Almighty Dollar. “As he explains in his memoir, German Chancellor Helmut Schmidt, who was a friend, lectured Volcker for almost an hour ‘about waffling American policymakers who had let inflation run amok and undermined confidence in the dollar.’ A shaken Volcker cut his trip short, got his fellow Fed members on board, and called an unusual evening press conference. Most dramatically, he stressed that he was shifting his key policy tool to monetarism. As a hedge, he also raised the Fed’s discount rate by a full point. The New York Times editorialized about the rate hike under the headline ‘Mr. Volcker’s Verdun,’ noting that when it came to holding the line on inflation, the Fed chairman’s message echoed that of Marshal Petain: ‘They shall not pass.’”

During his first two months on the job, Volcker raised the funds rate incrementally, keeping pace with the steady rise in inflation in a manner that was similar to the way his predecessor had conducted business. His first FOMC meeting after he became the Chair was business as usual, but Volcker hinted at changes that he intended to make, when the time was right. Sooner rather than later was his preference because he figured time was short and the risks were high.

First of all, the Fed had to be believed.

“That's the credibility problem (and the confidence) we have to establish as I see it. And we haven't got a helluva lot of time as the recession comes along—if indeed it does come along-but particularly if it gets worse,” said the new Fed Chair according to the transcript of the August 1979 FOMC meeting. “So, I think we can't ignore the psychological problem that we have at the moment. I don't know what the chances are of changing these perceptions in a limited period of time. But as I look at it, I don't know that we have any alternative other than to try.”

The scolding by Germany’s leader a couple months later was all the prompting Volcker needed to put his plan into action. Now known as the Reform of October 1979, “the centerpiece of the reform was the abandonment of federal funds targeting in favor of nonborrowed reserves targeting as the operating procedure for controlling the nation’s money supply,” explains the Fed paper called The Reform of October 1979: How it Happened and Why. Monetarism was now the modus operandi for the Fed. So, the central bank would control the money supply and the market would establish the funds rate based on the scarcity or abundance of money.

“This resulted in the unwelcome higher volatility of the federal funds rate during a few years following the reform,” the Fed paper notes. But the new strategy was able to achieve what the old strategy could not (Figure 2). “In the prevailing environment of high and increasingly unstable inflation, however, small adjustments in the federal funds rate had proven woefully inadequate for reining in monetary growth.”

Conclusion

From that day in early October 1979, Volcker would control the money supply and from that position he was also able to bring into order inflation expectations that he viewed as so crucial to the process. It was a matter of credibility for Volcker, both with the public and with the rest of the world as well. Because the respectability of the dollar was part and parcel of Volcker being able to slay the dragon.