Federal Reserve - Reagan Administration - Article Example

Name of writer appears here] [Course name appears here] [Professor’s name appears here] [Date appears here] Federal Reserve The 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). Other aspects of the new regime were unanticipated. Most economic opinion treats this strength as a function of real U.S. interest rates and the budget deficit, but the dollar's rise was neither anticipated nor well understood by either the Federal Reserve or the Reagan administration, nor was it predicted by contemporary economic theory. Oil prices began to decline in 1981 after rising horrendously in 1979 and 1980, providing vital assistance in the battle against inflation. At the time it looked like good luck, but in retrospect, it appears the natural outcome of economic forces (Greider, 1987). Initially, the effects of the new regime on the stock and bond markets looked like a worse version of the 1970s. It lost almost 25% between mid-1981 and mid-1982 so that it was still below its 1972 peak in mid-1982. It was not until the last half of 1982 that the stock market soared, providing a 35% return in six months and beginning a rise that by 1984 produced a highly satisfactory average annual total return of 14.8% (9.7% real) for the first half of the decade, compared to 5.9% (minus 1.5% real) between 1969 and 1979. However, this return was well below the average annual return from 1984 to 1989 of 20.4% (16.7% real) (Yergin, 1991). The bond market suffered horrendously at first and was the locus for many of the negative effects of the new regime. Rates for ten-year treasuries rose steadily from 7.2% to 12.8% between 1977 and early 1980, but, after a brief decline in mid-1980, they rose again to 15.3% in mid-1981. Again, as with stocks, it was not until the last half of 1982 that the bond market surged, producing total returns of 32% in six months. These gains, and the subsequent lesser ones, were large enough that the average annual return on longterm treasuries between 1979 and 1984 was 9.8% (4.7% real), compared to 5.5% between 1969 and 1979 (minus 1.9% real). As with stocks, bond returns from 1979 to 1984 were substantially below the returns from 1984 to 1989 of 15.5% (11.8% real) (Yergin, 1991). On the corporate side, the oil-related, metals, commodities, and equipment manufacturing industries suffered severely reduced credit ratios, the credit crises in the auto and electric utility industries were only resolved by considerable government intervention, and the farm crisis was still brewing. The administration formally published new "merger guidelines" in 1982, but in practice it began changing the antitrust rules immediately and loosened them further after 1982 with numerous case-by-case decisions. The change in attitude was particularly important to oil industry acquisitions, which were one-third of the total. There are good reasons for focusing on 1979-1984 separately from the second half of the 1980s. This was the period in which the change in regimes took place. It encompassed all of the trend changes in fiscal and monetary policy, the dollar, oil and other commodities prices, and inflation. Most of these factors, other than oil prices and the dollar, showed modest volatility during the balance of the decade. A corresponding shift in the attractiveness of the stock and bond markets from the discouragement of the 1970s occurred in this period, and it encompassed a highly distinctive period of record real interest rates. On a microeconomic level, most of the distress that developed in the oil-related, commodities, and equipment manufacturing industries was apparent within this period, as were the structural changes in the securities markets that became important in the last half of the decade, such as the growth in junk bonds, mortgage-backed securities, derivatives, and merger activity (Yergin, 1991). The changes in fiscal and monetary policies, the dollar, oil prices, and regulatory policies that accompanied the first Reagan administration constituted a dramatic change in regimes that broke the back of an extended sixteen-year inflation cycle and reestablished the attractiveness of securities markets. Ronald Reagan took office opposed to the wage and price controls, regulatory bent, and energy policies of the Carter administration, and espoused strong ideological commitment to free markets, lower taxes, economic growth, and the intention to lead the free world fight against communism -- themes particularly attractive to international owners of capital. Monetary policy was an equally important part of the new regime. Paul Volcker and the Federal Reserve are well recognized for their prolonged effort to reduce inflationary expectations, but it is worth a historical reminder that the Federal Reserve's aggressive easing in mid-1980 left its reputation in tatters, and that its effort only achieved constancy after Reagan was elected and personally gave it strong support. Less well recognized is the vital institutional role of the Federal Reserve in maintaining the stability of the international and domestic banking systems from 1982 to 1984, when the growth in both the economy and the securities markets could easily have been derailed by financial crises reminiscent of the 1930s (Greider, 1987). Fiscal and monetary policy combined unintentionally to produce a 55% rise in the dollar between 1980 and February 1985 that was an important part of the change in regimes. Linked to this strong dollar, but also some-what fortuitously, oil and other commodities prices began an extended decline in 1981 that lasted for the rest of the decade and was fundamental to the decline in inflation. The change in regimes took place over several years and involved contradictory crosscurrents, particularly the budget and trade deficits. The Reagan tax cuts of 1981 led to a federal deficit equal to 6% of GNP and a trade deficit of $112 billion (3% of GNP) by the end of 1984 that so unnerved many investors, as well as the Federal Reserve, that it was not until after the economic recovery of 1983-1984 that these centers of traditional financial opinion were prepared to concede that the twin deficits would not necessarily stimulate inflation. It was also several years before the economy and securities markets benefited from the change in regimes, and here, too, there were numerous contradictory crosscurrents, particularly the depression in the oil, metals, commodities, and trade-sensitive equipment manufacturing industries and the extreme fragility of the banking system (Sargent, 1981). The initial effects of these conscious policies, unintended effects, and fortuitous oil and other commodities price declines were a stinging recession in which industrial production showed no growth for thirty-six months and unemployment reached postwar records, a dramatic decline in inflation from 12% to 4%, and punishing securities markets until the Federal Reserve eased monetary policy in the last half of 1982 under the twin imperatives of economic growth and preserving the financial system. At that time, the tax cuts also began to take effect and the economy was able to grow strongly without inflation. By 1984 it was clear that expectations about inflation, wage rate growth, oil prices, the dollar, real interest rates, and profits growth had changed in important ways. Consumer confidence was also rising strongly. Whether one attributes the changes to the Reagan administration, the Federal Reserve, or the luck of a long-cycle commodities price decline is unimportant. From the point of view of the securities markets, they were all working together in the same direction. The powerful impact of the March anti-inflation program on consumers was indicated by the concentrated decline in credit-sensitive consumer durables. The 10% second-quarter decline in GNP was only 1.5% excluding autos and housing (Greider, 1987). The monetary shock abruptly reversed the intense inflation speculation of January and February. Gold futures, which had been as high as $960 an ounce in January, dropped to $469 on March 18th and closed April at $543. Silver prices, which had been over $50 an ounce in the futures market in January, dropped to under $10 when the Hunt brothers were caught under-margined at Prudential-Bache Securities and defaulted on a silver futures contract with Englehard Minerals for 19 million ounces worth $665 million. As a cheap play on gold, the Hunts had bought 170 million ounces of silver at prices up to $35 per ounce, and borrowed $1.8 billion in the process. Now they were caught in the largest personal bankruptcy in U.S. history. The change in other futures prices was reflected in a 13.5% decline in the Commodities Research Bureau's futures index in just four weeks (Sargent, 1981). Inflation as measured by the Consumer Price Index immediately declined to under 12% for March through May from the 16.4% average for December through February, and then to only 1.5% in June. Inflation as measured by the Producer Price Index (PPI) came down steadily from over 17% in January and February to 5.6% in May (Sargent, 1981). The stock and bond markets had been declining sharply for three weeks in anticipation of the administration's program, as virtually an of the details were discussed in advance in the press and with Congress. The stock market declined 16% from mid-February to mid-March, and ten-year treasury rates rose from 10.8% to 12.4%. After the anti-inflation program was announced, federal funds rates briefly soared to 25% versus 14.1% in February, and ten-year treasury rates initially rose slightly to 12.8%; however, as it became evident that monetary policy was dramatically cooling both the economy and inflationary expectations, ten-year treasury rates began to decline. The yield on ten-year treasury bonds went from 40 basis points under treasury bills (i.e., already inverted) to 610 basis points under between February and April. The S&P 500 initially dropped 10% from 113 to 102, but it too reversed direction quickly, and rose steadily for the rest of the year (Volcker, & Gyohten, 1992). Neither the administration nor the Federal Reserve anticipated such a quick reaction to the March anti-inflation program, but it was certainly convenient with the election so near. The Federal Reserve abruptly eased credit between May and July. The credit controls were dismantled and the discount rate reduced by six points to 10The yield on ten-year treasury bonds dropped from 13% to 10%, and the yield curve from threemonth treasury bills to ten-year U.S. treasuries was positive by 279 basis points after being negative by 610 basis points in April. The S&P 500 rose 15%, from 106 at the end of April to 122 at the end of July. The economy surged back, and the consumer confidence index rose from 51.7 in May to 76.7 by November. The Index of Leading Indicators rose from 93.6 in May to 104.1 in November, and the National Association of Purchasing Managers' index rose from a low of 29.2 in May to 56.0 in November. The Federal Reserve's industrial production index rose from 140.4 to 148.5 as industrial capacity utilization recovered from 79% in July to 82.5% in December. 20 But inflation also began to escalate again. Oil prices rose to $40, and drought in the Midwest drove corn prices from approximately $2.50 to $3.50 a bushel, and cotton from 65 cents to 80 cents. The Commodity Research Bureau's Futures Price Index rose from 260 in April to 330 in September-- a 53% annual rate of increase! The Consumer Price Index grew at a 12.0% rate from September through December (Volcker, & Gyohten, 1992). In fact, inflation had never really declined to the same extent as the economy or interest rates in response to the March anti-inflation program. The sharp turnaround in monetary policy did much to undermine faith in the Federal Reserve's efforts to control inflation. Political motivations appeared to be the Fed's chief weakness in preventing the buildup of inflation under chairmen Burns and Miller, and now Paul Volcker appeared too involved in politics. He had been intensely involved with the Carter administration in preparing the March anti-inflation plan. His involvement went far beyond simply monetary policy, including White House strategy sessions and discussions with Congress in which political considerations were frank and immediate, all of which made the Fed look overtly political when it cut the discount rate by six percentage points, reduced banks' borrowed reserves back to the low levels of 1977, and dismantled the consumer credit controls in just two and a half months (Volcker, & Gyohten, 1992). M1 was allowed to grow 14.6% in the third quarter, and M2 grew 16.0%. Lacking confidence in the Fed's political motives, the dollar sank 6%, back to its December 1979 level, and gold futures rose almost 50% to $748 (Ibbotson Associates, 1989). The Federal Reserve could not be inactive in the face of rapidly rising inflation and this money supply expansion right in front of the election, however, without appearing a total tool of the administration. The Federal Reserve raised the discount rate from 10% to 11% in September, which was the extent of its public action. Federal funds rose from 9.0% in July to 12.8% in October, and banks' borrowed reserves rose from 0.4% of required reserves to 3.9% in the same period. But the Federal Reserve felt compelled to wait until after the November elections to make an all-out attack on inflation. It raised borrowed reserves to 5.9% in November, federal funds to 19% in December, and actually reduced Ml by 12.5% in December. Conclusions The first Reagan administration marked a change in policy regimes that sharply reduced inflation, set the foundation for a record period of steady economic growth, revived the stock and bond markets, and initiated a merger boom without modern parallel. The federal authorities contributed a set of explicit policy decisions to this new regime -- monetary policy that was aggressively anti-inflationary, fiscal policy that reduced taxes, and free-market prejudices that disbanded wage and price controls, attacked unions, ceased energy regulation and incentives, and freed industry of most antitrust controls. Some aspects of the new regime were fortuitous, such as the drop in the price of oil from $40 a barrel to $25, the 55% rise in the dollar, and the decline in credit standards for bank loans and junk bonds that fueled the growth in the merger market, although it must be said that Reagan administration policies fostered and often welcomed these trends. The administration's policies also contrasted strongly with those of the Nixon and Carter administrations, under which the Federal Reserve was more concerned with economic growth than inflation, wage and price controls were favored, and there was extensive intervention in the energy industries -- policies that led to rising inflation, a weak dollar, and frequent crises in the foreign exchange and financial markets. The eventual results in securities markets and the economy were very much what the proponents of the new regime had promised -- lower inflation, steady economic growth, and rewarding stock and bond markets. Inflation dropped below 3%, the economic recovery during 1983-1984 was a postwar record, the stock market had a solid 14.8% compound annual total return from the end of 1979 to the end of 1984, and longterm treasuries had a real compound annual return of 3.3% -- the best record for five years running since 1929 (Ibbotson Associates, 1989). However, the proponents of the new regime had not anticipated that the transition to these favorable results would be so painful. It involved thirty-six months without an increase in industrial production, a postwar record of 10.8% unemployment, bankruptcy of many less-developed countries, credit crises in the auto, farm, electric utility, banking, and savings and loan industries, historically high interest rates, and wrenching stock and bond markets in which, by mid-1982, stocks were still below their peaks of a decade earlier and investors in long-term treasuries had only half the real value of their capital in 1976. The readjustment was particularly painful to the auto, oil, chemical, metals, farm, and heavy machinery industries, which entered into long-term declines, and whose stocks shifted from overperforming the S&P 500 in the inflationary 1970s to long-term underperformance. Nor had the proponents of the new regime reckoned on the adept institutional management of the multiple crises that was necessary to the favorable outcome. Federal authorities and the leading commercial banks had to work with international lending authorities and the less-developed countries with great finesse to prevent an international banking crisis. The savings and loan industry had to be restructured to survive, and Continental Illinois Bank & Trust was virtually nationalized for the sake of the stability of the money center banks. The auto industry was saved by controls on Japanese imports, easier emission and gas mileage requirements, and continuation of the Carter administration's promised aid to Chrysler Corp. Distress in the nuclear sector of the electric utility industry was in part alleviated by almost $10 billion in aid received indirectly from the Rural Electrification Administration. And the farm community went through a prolonged credit liquidation that culminated in the need to bail out the Farm Credit System in 1985 -- just over the horizon of our present focus. In short, the favorable outcome of the new regime was dependent on highly adept institutional solutions to a surprisingly large number of crises. Reference: Daniel Yergin, The Prize, New York: Simon & Schuster, 1991, p. 694. Ibbotson Associates, Stocks Bonds Bills and Inflation 1989 Yearbook, Chicago, Ill.: Ibbotson Associates, 1989. pp. 201, 207. Paul Volcker, and Toyoo Gyohten, Changing Fortunes, New York: Times Books, 1992, pp. 166-168. Thomas J. Sargent, "The Ends of Four Big Inflations," in Robert E. Hall (ed.), Inflation: Causes and Effects, Chicago: University of Chicago Press, 1983; and Robert E. Lucas, "Econometric Policy Evaluation: A Critique," in Studies in Business Cycle Theory, Cambridge, Mass.: M.I.T. Press, 1981. William Greider, Secrets Of The Temple. New York, NY; A Touchstone Book, Published by Simon & Schuster Inc.: 1987 Read More