The Volcker Letters

Like thousands of small companies, family-owned Eastern Steel Metal Co. relies heavily on bank debt to finance its inventory and operations. When interest rates go up, the Milford, Conn., company feels the pinch all the way down to its earnings. Last year, after watching rates rise yet again for no reason that was apparent to him, Eastern chairman Paul Goodwin took his frustration to the man he thought could ease it, Federal Reserve Board chairman Paul A. Volcker. Three letters and three replies later, Goodwin was still frustrated. The two chairmen had exchanged opinions, but had reached no understanding. Edited for publication, the letters appear below.

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March 26, 1984

Dear Mr. Volcker:

The prime interest rate has been increased by .5%, and it is incredible to me that the banks are able to increase this rate without a murmur from anyone, including our legislators!

The ostensible reason for this increase is that the economy is moving forward, the demands for credit are increasing, and there is a shortage of lending funds. Yet, in spite of this so-called shortage, enough money appears to be available for oil mergers and acquisitions worth $16 billion or more, to say nothing of the other mergers and acquisitions currently taking place.

Can you not know that as these interest rates move upward they contribute to the inflation that they are supposed to control? Do you not recognize that in the short and long run they contribute to the national deficits about which everyone is so concerned? Can you explain how, when we were in the worst recession since the 1930s, there was no movement of interest rates downward? Can you explain the huge growth in profits of most banks when there are such huge calamities taking place in the industrial world? Is the average business supposed to make up the difference for the huge loans made by the banks to Third World countries now in, or threatening, default?

Who speaks for the average businessperson, who must now increase the costs of doing business with no commensurate return? What will happen to the businessperson who must project costs when economists, bankers, and the government constantly disagree on the effects of their own actions? For instance, we are told that if the deficit is not dealt with and that if M-1 is not maintained within certain goals, interest rates will surely rise. Yet in the past two weeks, while M-1 decreased by $3 billion and while it appeared reasonably certain that the deficits were being dealt with, at least minimally, interest rates nonetheless went up.

I am yelling blue bloody murder, and I assure you that I am speaking for millions of people -- businesspeople, homeowners, builders, and consumers -- who are assaulted by the system.

What can you do about this? Please do not send me form letters.

Sincerely yours,

Paul Goodwin

May 9, 1984

Dear Mr. Goodwin:

Thank you for your recent letter in which you raise several questions with respect to interest rates and our monetary policy goals.

In your letter, you take the view that rising interest rates contribute to inflation. Although it is true that financing costs do affect the final costs of goods and services, the production of which depends on credit, this "micro" effect on prices may have a long lag and at times may even be offset by other factors. Also, the "micro" effect may be more than offset by the "marco" effect higher rates produce by damping credit demands. But, I would emphasize that none of these effects are instantaneous. The primary role of interest rates is to allocate credit to its most productive uses and to bring credit demands into balance with supplies. Recent upward pressures on rates have reflected strong credit demands, both by the federal government and the private sectors. These pressures boosted market rates generally, including the cost of funds to banks, and the recent increases in the prime rate have been roughly in line with other market rates.

The Federal Reserve could attempt to resist such upward pressures on interest rates by aggressively increasing the supply of money and credit. However, this action would at best be successful for only a short period of time, since it would be widely perceived as risking the reignition of inflationary fires. In short order, the inflationary premium embedded in interest rates would start to rise. For this reason, the high cost of financing the outsized federal deficit cannot be reduced fundamentally by a policy of boosting monetary growth. Accordingly, the key to the lower levels of interest rates that we all seek is meaningful action to bring federal spending and revenue into closer alignment.

Although some aspects of the implementation of monetary policy may be highly technical, as you suggest, the Federal Reserve's policy goals are quite straightforward: to provide sufficient growth of money and credit to promote a sustainable rate of economic growth while continuing to exert downward pressure on inflation.

I hope these comments have been useful.

Sincerely,

Paul A. Volcker

June 18, 1984

Dear Mr. Volcker:

I want to thank you very much for your response t? o my recent letter.While I appreciate the time you have taken, I cannot honestly feel that your response has answered the questions I raised.

It is true that the immediate effect on prices may lag interest-rate changes, but it is equally true for many of us trying to operate our businesses that increased interest rates hit us immediately.

Your statement that the primary role of interest rates is to allocate credit to its most productive uses and to bring credit demand into balance with supply sounds reasonable enough, but how is this actually applied? Do you consider mergers financed by loans to be" productive uses"? I don't, and would venture to say that any thoughtful and reasonable person would not consider that money pent in acquisitions is in any way productive to our economy.

No one would fault a policy that has as its aim restraint of inflation, but the confusing signals, signs, and results bewilder me. If the Federal Reserve exercises controls to protect us from inflation, and we accept what the Federal Reserve System has to say about cause and effect, why does it not perform consistently? We can remember in 1980 when the prime interest rate was 21.5%, and the reason given was not an unbalanced budget so much as it was double-digit inflation. Now inflation is down to the lowest level in many years, and the new excuse for higher interest rates is the excessive budget deficits.

Don't you see the frustration that we on the sidelines have to face?

Sincerely yours,

Paul Goodwin

June 28, 1984

Dear Mr. Goodwin:

I'm sorry to read that you did not find the responses I gave to your earlier questions fully satisfactory. It may be that there are some irreconcilable differences in our views, but let me attempt at least to clarify my position by making a few key points.

First, the Federal Reserve does not have anything approaching absolute control over interest rates and lending behavior. Our influence on credit conditions is a broad one and must be focused primarily on contributing to the longer range stability of the economy. Within this context, interest rate levels are going to be powerfully affected by the credit demands of the federal government (related to the size of the budget deficit) and those of private borrowers; they also are going to be much affected by the sometimes volatile expectations of investors, based on shifting perceptions of governmental policies and economic prospects. There is no iron law of "real" interest rates that says that the differential between nominal interest rates and the prevailing rate of inflation should be constant over time. Variations in tax laws, in inflation expectations, and in a multitude of other factors will alter the size of that differential, which is consonant with given patterns of economic performance. If the Federal Reserve were to seek aggressively to offset these many influences, we would do so only at the sacrifice of the useful allocative functions performed by market-determined prices (including that of credit), and ultimately of the stability of the economy.

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