Essays on About Federal Reserve Article

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Federal ReserveThe decade of the 1980s was one of the most favourable in the twentieth century for securities markets. The stock market had an average annual total return of 17.5%, as Standard & Poor's Composite Stock Price Index (the S& P 500) rose from 108 to 353. This was the second best decadal return since 1929--only bettered by the 19.3% return of the 1950s when the world was recovering from the Depression and World War II. Long-term government bonds had the best annual returns since 1929 (12.6%) as ten-year treasury rates declined from 10.4% to 7.8%.

Real returns were equally impressive (Yergin, 1991). The 1970s were plagued by repeated crises over oil prices, inflation, and the dollar. In the last half of the 1970s, the Carter administration's efforts to deal with these problems were erratic and unsuccessful. There were financial crises in 1978, October 1979, early 1980, and yet another crisis was building in late 1980 as President Carter left office. The administration's emphasis on wage and price controls and energy regulation, and the Federal Reserve's weak application of monetary policy prior to October 1979 and its erratic application in 1980, rendered the prospect for steady economic growth poor and the securities markets subject to constant outside shocks (Greider, 1987).

The election of President Reagan introduced a new regime in more ways than one. There was a dramatic reduction in personal income taxes and a tripling of the federal deficit as a share of gross national product (GNP) from 2% to 6%. There was a shift to free-market policies that did away with wage and price controls and intervention in the energy markets.

And there were 180-degree changes in the trends of the dollar, oil, other commodities prices, and inflation generally, and a complete revision of antitrust policies. Most important, monetary policy under the aegis of Paul Volcker, strongly supported by President Reagan, was firmly established as the tool for suppressing inflation (Volcker, & Gyohten, 1992). There are various theoretical ways of describing the difference between the 1970s and the 1980s. Economists, such as Thomas J. Sargent and Robert E. Lucas, 2 have theorized about changes in regimes or rational expectations. Thomas Kuhn has developed the concept of a new paradigm.

Financial professionals think in terms of new valuation parameters, new trends, or a change in fundamentals. The common investor would simply resort to the well-worn phrase, "this time it's different. "The administration's acceptance of a tripling in the deficit from 2% to 6% of GNP appeared to run totally counter to controlling inflation, which created a constant battle over whether taxes should be raised following the 1981 reductions. Likewise, the Federal Reserve only appeared staunchly directed against inflation in retrospect.

Its abrupt easing of monetary policy in the middle of 1980 severely hurt its credibility at the time and its degree of restraint fluctuated under political and economic pressures during 1981. The decline in inflation--the most important indicator of the change in regimes--was almost the only thing that was smooth. As measured by the consumer price index (CPI), it declined from 13.3% in 1979 to approximately 4% between 1982 and 1984, as the United States finally broke its sixteen-year trend of escalating inflation. Inflation had been rising steadily from 1% in 1964 to a monthly peak of almost 15% in early 1980, ratcheting up in the peaks and troughs of each business cycle.

The disjunction occurred sharply in the fourth quarter of 1981 (not shown), after which hitherto predictable relationships between inflation and money supply, unemployment, and interest rates were disrupted, as inflation declined steadily and remained low in the recovery of 1983-1984. At that point, the new expectations were the basis for a period of uninterrupted GNP growth that stretched from the fourth quarter of 1982 through the third quarter of 1990--the longest period on record, and a sharp contrast to the stop-and-go experience of the 1970s (Yergin, 1991).

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