Monetary policy ; Federal Open Market Committee

Edwin M. Truman

English

Research Papers in Economics

FEDERAL RESERVE BANK OF ST. LOUIS REVIEW MARCH/APRIL, PART 2  2005 353
Reflections
Edwin M. Truman
CORRECT DIAGNOSIS?
The Carter administration came into office
dissatisfied about U.S. economic growth and
determined to lead an international effort to pro-
mote U.S. and global expansion—the locomotive
theory. Economic activity did accelerate in the
United States in 1977, and so did the price level,
but most of the rise was in increases in prices of
food and energy. The U.S. current account deficit
also widened, which was seen as sapping the U.S.
expansion. This situation prompted Treasury
Secretary Blumenthal in June 1977 to make his
comments on the unsustainable U.S. deficit at
the Organisation for Economic Co-operation and
Development (OECD). These comments estab-
lished his reputation for “talking down” the dollar.
By the fall of 1977, the Federal Reserve was
intervening quite heavily (by the standards of
the time) in foreign exchange markets to resist
the dollar’s decline. That decline was seen at the
Federal Reserve and in other policy circles as
adding to U.S. inflation. We on the international
side of the Federal Reserve at this time used to
joke that the view at the Federal Reserve seemed
to be that inflation was caused by rising prices;
Federal Reserve policy had nothing to do with it.
With the transition from Arthur F. Burns to
G. William Miller as Chairman, the situation did
not improve, though Miller was more effective in
dealing with the administration. He succeeded
where Burns had failed—in convincing the U.S.
Treasury that the Treasury could absorb the poten-
tial financial costs of issuing foreign currency–
denominated debt (what came to be known as
Carter bonds) as a cost of issuance. 
M
y reflections on the new operating
procedures that were adopted
by the Federal Open Market
Committee (FOMC) on October 6,
1979, derive from my responsibilities at the
Federal Reserve Board at the time. Those respon-
sibilities included preparation of the international
component of the staff forecast, analysis of econ-
omic and financial developments in other coun-
tries, and assisting the Chairman and members
of the Board (primarily Henry C. Wallich) with
international responsibilities in connection with
their attendance at international meetings. There-
fore, mine was and is an international perspective.
I was not involved in the design of the new oper-
ating procedures, although I was informed that
the project was under way.
The decision on October 6, 1979, was very
much part of an international policy coordination
process that played out with our partners abroad,
principally in Europe, as well as within the U.S.
government, in the late 1970s. In thinking about
such episodes of policy coordination, I find it
useful to try to answer a sequence of questions:
(i) Was the diagnosis of a need for policy action
correct? (ii) Was there agreement on the model
or framework used to analyze the situation? (iii)
Were the right policy choices made? My reflections
are organized around those three questions. My
answers are as follows: (i) Eventually the correct
diagnosis was made. (ii) Agreement on the analytic
framework was loose at best. (iii) The right choices
were made, but in retrospect at a high price that
probably would be higher today.
Edwin M. Truman is a senior fellow at the Institute for International Economics. In October 1979, he was director of the Division of
International Finance of the Board of Governors of the Federal Reserve System (1977-98). 
Federal Reserve Bank of St. Louis Review, March/April 2005, 87(2, Part 2), pp. 353-57.
© 2005, The Federal Reserve Bank of St. Louis.The dollar continued to decline after the
Bonn Summit in July 1978, at which the grand
bargain was struck to stimulate growth abroad in
return for a U.S. pledge to reduce its dependence
on imported oil. The decline turned into more of
a free-fall in October in reaction to the announce-
ment of President Carter’s program of budget
restraint and voluntary wage and price guidelines.
The Federal Reserve under Chairman Miller
anticipated this reaction, and a plan was devel-
oped to correct “the excessive exchange rate move-
ments” that followed the announcement. The
plan called for a cooperative $30 billion package
of foreign currency resources to finance Treasury
and Federal Reserve intervention. However, it
was noteworthy that the Bundesbank would not
agree to the package, which included doubling
the Federal Reserve’s swap line with it and coop-
eration on the issuance of Carter bonds, until the
Federal Reserve agreed to a decisive monetary
policy move that took the form of an unprece-
dented 1-percentage-point increase in the dis-
count rate to 91/2 percent.
The President’s announcement of the overall
package tightly linked the decline in the dollar to
U.S. inflation. However, there was little recognition
at the time in Washington that the United States
had a serious underlying inflation problem. One
of my least pleasant experiences at the Federal
Reserve was in July 1978, when I represented the
Federal Reserve on the U.S. delegation for the
OECD’s review of the U.S. economy. Lyle Gramley,
who had moved to the Council of Economic
Advisers (CEA), argued that if the Federal
Reserve raised interest rates another 25 basis
points, it would plunge the U.S. economy into
recession.1 I said the Federal Reserve would act
“appropriately.”
The November 1, 1978, package boosted the
dollar for a while. However, in June 1979 it began
to decline again, in particular in terms of the
Deutsche mark. Petroleum prices were also rising
along with U.S. headline and core inflation. During
the summer of 1979, the principal response both
inside and outside the Federal Reserve was to
call for stepped-up U.S. intervention in foreign
exchange markets. It was felt that the economy
was headed for recession, so the scope for raising
interest rates was limited.2
During that summer, the FOMC did push up
the federal funds rate at the same time it was
participating in foreign exchange market inter-
vention. By September, it was becoming increas-
ingly clear that we were behind the curve. The
new operating procedure was under development
in-house.
Paul Volcker, who was appointed as Federal
Reserve Chairman in 1979, traveled to the Inter-
national Monetary Fund/World Bank annual
meetings in Belgrade on the Treasury plane. On
the way, they stopped in Hamburg for conversa-
tions with their German counterparts. One inter-
pretation of that stop was that Treasury officials
were trying to drum up German support for a new
rescue package for the dollar. In fact, they received
a harangue from the German authorities about
getting the U.S. economic house in order. It was
on this trip that Volcker informed the Treasury
and the CEA about his thinking. My impression
at the time was that the Treasury (Secretary Miller
and Under Secretary Solomon) was broadly sup-
portive of Volcker’s plans. My impression was that
the CEA (Chairman Schultze) was more skeptical
about the technique but not about the need to do
something. Most were convinced that everything
else had been tried and had failed; it was neces-
sary to have done so in order to bring them around
to accepting the need for fundamental monetary
policy action.
Volcker also shared some of his thinking in
general terms with Bundesbank president Otmar
Emminger. Emminger relied heavily for advice on
my good friend and counterpart at the Bundesbank,
Wolfgang Rieke. Consequently, during our walks
around Belgrade, Wolfgang and I had several
long conversations about the proposals and the
chances of their success. We thought we under-
stood how the new procedure would work, but we
were uncertain about how successful it would be.
Volcker left Belgrade early to return to
Truman
354 MARCH/APRIL, PART 2 2005 FEDERAL RESERVE BANK OF ST. LOUIS REVIEW
1 By the time Lyle Gramley came back to the Federal Reserve in
May 1980 as a governor, he was one of the strongest anti-inflation
hawks.
2 At the time, real GDP recorded a decline during the second quarter
of 1979, but the data today show no decline until the second
quarter of 1980.
 Washington to finalize plans for the October 6
meeting of the FOMC. Henry Wallich and I flew
back the afternoon of October 5 and immediately
went into a conference call to cover recent econ-
omic and financial developments, getting them
out of the way before the FOMC meeting the next
day. It was noted that the Pope would be in
Washington at the same time, which might give
the Reserve Bank presidents and their colleagues
some cover as they slipped into town.
By October 6, 1979, the FOMC had become
convinced that the United States had an inflation
problem that could be addressed only at home
through monetary policy, and the U.S. adminis-
tration, some very reluctantly, did not object. The
inflation problem had its origins inside the United
States and inside the Federal Reserve, not in for-
eign exchange or petroleum markets. Eventually
the correct diagnosis was made.
AGREEMENT ON THE ANALYTICAL
FRAMEWORK?
In Belgrade, Arthur F. Burns delivered the Per
Jacobsson lecture, named after a former managing
director of the International Monetary Fund. His
title was “The Anguish of Central Banking.” He
argued implicitly that the fault for high U.S. infla-
tion lay not primarily with the Federal Reserve
but in policy decisions made elsewhere in the
U.S. government that limited the central bank’s
capacity to bring down inflation, especially once
it had risen.
Burns presented a four-part proposal for how
the U.S. government should deal with its inflation
problem: (i) revision of the budget process, (ii) a
comprehensive plan for dismantling regulations
impeding the competitive process and modifica-
tions where regulations were driving up prices
and costs, (iii) scheduled reductions in business
taxes to stimulate the supply side of the economy,
and (iv) “a binding endorsement of restrictive
monetary policies until the rate of inflation has
become substantially lower.” Volcker arrived late
at the lecture, sat on the floor leaning against a
wall, picked up a copy of Burns’s speech, skimmed
through it, and tossed it back on the floor with the
comment, “I’m doing it all wrong.” I was sitting
a few feet away and was one of the few who heard
him and understood what he really meant.
However, Arthur Burns was not the only per-
son who did not embrace the unilateral approach
to monetary policy that the Federal Reserve was
about to unveil. The members of the FOMC only
gradually arrived at a common diagnosis of the
problem. They were concerned about inflation,
but they were also concerned about the real econ-
omy. There was less than full agreement that a
greater focus on the monetary aggregates was
appropriate in the context of ongoing changes in
the financial system. The Federal Reserve had
embraced the framework of monetary targeting, and
it was enshrined in the Humphrey-Hawkins Act,
but the embrace was far from warm or universal.
Even for those who embraced the monetarist
framework, there was considerable dissatisfaction
with the current operating procedures and doubts
about whether they could achieve the monetary
targets. Of course, considerable attention was paid
to interest rates. However, my memory is that the
term “real short-term interest rates” was rarely
used at the time. Through the third quarter of 1979,
the real federal funds rate (adjusted for headline
consumer price index [CPI] inflation over the
following four quarters) had been positive for only
2 of the 19 quarters starting in the first quarter of
1975. This experience has led me, for example,
in the context of the Mexican program in 1995,
to favor use of the real short-term interest rate as
an indicator of monetary restraint.
The new operating procedures were regarded
generally as a monetarist framework, but many
monetarists disowned it either immediately or
soon thereafter. Moreover, during the period
through the middle of 1982, in which the new
operating procedures were more or less opera-
tional, there were discussions at every meeting
about how wide or binding the federal funds
constraint should be, though it was generally not
binding. Of course, during the second quarter of
1980, the entire program was disrupted by the
imposition of credit controls along with the nego-
tiation of a new package of budget cuts.
On balance, there was more agreement in 1979
that “something” should be done about U.S. infla-
Truman
FEDERAL RESERVE BANK OF ST. LOUIS REVIEW MARCH/APRIL, PART 2 2005 355tion than about “what” should be done or “why”
it should be done. Thus, I conclude that agreement
on the analytic framework underlying the new
operating procedure was loose at best. While the
disinflation objective was clear, substantial uncer-
tainty remained about how best to achieve that
objective, which itself was unspecified.
THE RIGHT POLICY CHOICES?
The Federal Reserve was right to turn its atten-
tion directly to the underlying inflation problem
in the U.S. economy rather than treat its symp-
toms (via exchange market intervention) or com-
plaining about them (oil prices). The device of
the new operating procedures, with its focus on
nonborrowed reserves, was widely viewed at the
time as a smokescreen for pushing up real short-
term interest rates. Even if that was not the moti-
vation, high interest rates were the result. It might
have been preferable to announce an explicit
inflation goal, but that was not among the central
banker’s bag of tricks at the time. Moreover, it was
pretty clear that substantial disinflation was the
Federal Reserve’s broad objective.
The cost of that disinflation was very high—
certainly higher than expected by those who
argued that choosing a tough monetary target and
sticking to it would magically lead to an adapta-
tion of expectations of inflation, with no loss in
output. It was even higher than others, such as
myself, who suspected that it would be a long and
painful process, thought it would be. Of course,
other developments messed up the experiment:
the continued rise in oil prices, the credit controls,
and the fiscal policy of the Reagan administration,
for example.
Criticism of Federal Reserve policy from
Treasury Secretary Regan and Treasury Under
Secretary Sprinkel helped to foster the most har-
monious period within the Federal Reserve that
I experienced in my 26-plus years. It is noteworthy,
however, that the new operating procedure and
associated actions were intended to increase con-
fidence abroad as well as home in the System’s
determination to curb inflation by moderating
expectations of inflation; this was expected to
strengthen the dollar. Yet, the foreign exchange
value of the dollar did not really turn around until
the end of 1980, both on the G-10 average that we
were then using and against the Deutsche mark;
the dollar hit new lows in January 1980 and came
close to those lows again in July. The foreign
exchange markets remained skeptical, although
to some extent pressures for the dollar to appre-
ciate were resisted by other countries who were
worried about “importing inflation” in the con-
text of the surge in global energy prices.
I recall that, at a Congressional hearing shortly
before the end of his tenure at the Federal Reserve,
Paul Volcker was asked whether he would have
done it—that is, tried to persuade the FOMC to
adopt something like the new operating proce-
dures—if he had known how long and painful it
would be to get the process of disinflation going
in the U.S. economy. His answer, as I recall, was
a rather crisp “I am not sure.” At the same time,
he left no doubt that action was necessary and
inevitable. The only issue was the timing.
Coming back to the international perspective,
one consequence of the sequence of the Federal
Reserve’s decisions, which had the effect of push-
ing up real interest rates to very high positive
levels after a long period of negative real rates,
was the international debt crisis that started in
1982 and lasted through the decade of the 1980s.
One can properly argue that the 1982 crisis was
also a consequence of lax U.S. monetary policy
in the late 1970s as well as a number of other
institutional factors. However, some of us felt an
obligation to help manage the adjustment process
that Federal Reserve policy and its failures had
helped to necessitate. It was, perhaps, prophetic
that at the August 1979 FOMC meeting the Com-
mittee authorized an increase in the Federal
Reserve swap line with the Bank of Mexico from
$360 million to $700 million.
I have my doubts whether today, when the
Federal Reserve is even more the central bank to
the world and despite the more widespread adop-
tion of floating exchange rate regimes, the Federal
Reserve could “get away with” imposing such a
draconian policy on the global economy without
more consultation, or at least warning. Thus, in
broad terms, the right policy choice was made in
1980, given the circumstances, but the price was
Truman
356 MARCH/APRIL, PART 2 2005 FEDERAL RESERVE BANK OF ST. LOUIS REVIEWhigher than anyone expected at the time. To delay
any longer would have raised the price, but greater
knowledge of how high the price was likely to be
might well have contributed to further delay.
In conclusion I offer three comments about
the relevance of that experience for the world
today. First, I observe that the real short-term
federal funds rate (again, adjusted for headline
CPI inflation over the following four quarters)
has been negative since the fourth quarter of 2001.
On the present trajectory it is not likely to turn
positive until the second half of 2005 or later.
Second, it is important that the Federal Reserve
never again promotes or experiences such an infla-
tion process. Through the end of 1998, when I
left the Federal Reserve, I felt that the FOMC con-
tinued to internalize the painful lessons of the
1977-82 period of inflation and disinflation; I hope
that is still true. Third, in this spirit, I support the
adoption of inflation targeting as a framework for
the management and evaluation of U.S. monetary
policy, not only to help prevent a replay of the
experience of 25 years ago but also as a commu-
nication device that would alert the rest of the
world if we should go off course and warn them
that ultimately the return to price stability would
be painful not only for us but for them.
Truman
FEDERAL RESERVE BANK OF ST. LOUIS REVIEW MARCH/APRIL, PART 2 2005 357358 MARCH/APRIL, PART 2 2005 FEDERAL RESERVE BANK OF ST. LOUIS REVIEW

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