time), and it too makes decisions by majority rule. While the Board chairman
is traditionally the chair of the FOMC, he or she must be elected each year
by the members, and they are free to choose someone else. I expected precedent
to prevail. But I was always aware that a revolt of the six other governors
could remove all of my authority, except writing the Board agendas.
*When the FOMC changes this rate, the committee directs the Fed's so-called open market
desk in New York to either buy or sell treasury securities—often billions of dollars' worth in a
day Selling by the Fed acts as a brake, withdrawing from the economy the money received in
the transaction and pushing short-term interest rates higher, while buying does the reverse. Today
the fed funds rate that the FOMC is seeking is publicly announced, but in those days it
wasn't. So Wall Street firms would assign "Fed watchers" to divine changes in monetary policy
from the actions of our traders or changes in our weekly reported balance sheet.
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I quickly got hold of Don Kohn; the FOMC secretary and had him
walk me through the protocols of a meeting. (Don; who would prove to be
the most effective policy adviser in the Fed system during my eighteen
years, is now vice chairman of the Board.) The FOMC held its meetings in
secret, so I had no idea what the standard agenda or timetable was, who
spoke first, who deferred to whom, how to conduct a vote, and so on. The
committee also had its own lingo that I needed to get comfortable with. For
example, when the FOMC wanted to authorize the chairman to notch up
the fed funds rate if necessary before the next regular meeting, it did not
say, "You may raise interest rates if you decide you have to"; instead it voted
to give an "asymmetric directive toward tightening."* I was scheduled to
run one of those meetings the following week, on August 18, so I was a
highly motivated student. Andrea still jokes about my coming over to her
house that weekend to curl up with Robert's Rules of Order.
I felt a real need to hit the ground running because I knew the Fed
would soon face big decisions. The Reagan-era expansion was well into its
fourth year, and while the economy was thriving, it was also showing clear
signs of instability. Since the beginning of the year, when the Dow Jones Industrial
Average had risen through 2,000 for the first time, the stock market
had run up more than 40 percent—now it stood at more than 2,700 and
Wall Street was in a speculative froth. Something similar was happening in
commercial real estate.
The economic indicators, meanwhile, were far from encouraging. Huge
government deficits under Reagan had caused the national debt to the public
to almost triple, from just over $700 billion at the start of his presidency
to more than $2 trillion at the end of fiscal year 1988. The dollar was falling,
and people were worried about America losing its competitive edge—
the media were full of alarmist talk about the growing "Japanese threat."
Consumer prices, which had gone up just 1.9 percent in 1986, were rising
at nearly double that rate in my first days in office. Though 3.6 percent inflation
was far milder than the double-digit nightmare people remembered
from the 1970s, once inflation begins, it usually grows. We were in danger
*For the record, even as I learned "Fedspeak," I would joke to the staff, "Whatever happened to
the English language?"
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of forfeiting the victory that had been gained at such great misery and cost
under Paul Volcker.
These were vast economic issues, of course, far beyond the power of
the Fed alone to resolve. Yet the worst course would be to sit idly by. I
thought a rate increase would be prudent, but the Fed hadn't raised interest
rates for three years. Hiking them now would be a big deal. Any time
the Fed changes direction, it can rattle the markets. The risk in clamping
down during a stock-market surge is especially acute—it can pop the bubble
of investor confidence, and if that scares people enough, can trigger a
severe economic contraction.
Though I was friendly with many of the committee members, I knew
better than to think that a chairman who had been around for a week could
walk into a meeting and shape a consensus on such a risky decision. So I did
not propose a rate increase; I simply listened to what the others had to say.
The eighteen committee members* were all seasoned central bankers and
economists, and as we went around the table comparing assessments of the
economy, it was apparent that they, too, were concerned. Gerry Corrigan,
the gruff president of the New York Fed, said we ought to raise rates; Bob
Parry, the Fed president from San Francisco, reported that his district was
seeing good growth, high optimism, and full employment—all reasons to
be leery of inflation; Si Keehn from Chicago agreed, reporting that the
Midwest's factories were running near full capacity and that even the farm
outlook had improved; Tom Melzer of the St. Louis Fed told of how even
the shoe factories in that district were operating at 100 percent; Bob Forrestal
from Atlanta described how his staff had been surprised at the
strength of employment figures even in chronically depressed sections of
the South. I think everyone walked away persuaded that the Fed would
have to raise rates soon.
The next opportunity to do so was two weeks later, on September 4, at
a meeting of the Board of Governors. The Board controls the other main
lever of monetary policy, the "discount rate" at which the Federal Reserve
lends to depository institutions. This rate generally moves in lockstep with
the rate on fed funds. Prior to the scheduled Board meeting, I spent a few
*There was one vacancy on the Federal Reserve Board.
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days working my way up and down the corridor seeking out the governors
in their offices, building consensus. The meeting, when it came, moved
quickly to a vote—the rate increase, from 5.5 percent to 6 percent, was approved
by the governors unanimously.
To subdue inflationary pressures, we were trying to slow the economy
by making money more expensive to borrow. There's no way to predict
how severely the markets will respond to such a move, especially when investors
are gripped with speculative fervor. I couldn't help but remember
accounts I'd read of the physicists at Alamogordo the first time they detonated
an atom bomb: Would the bomb fizzle? Would it work the way they
hoped? Or would the chain reaction somehow go out of control and set the
earth's atmosphere on fire? After the meeting ended, I had to fly to New
York; from there I was scheduled to leave that weekend for Switzerland,
where I was attending my first meeting of the central bankers of the ten
leading industrialized nations. The Fed's hope was that the key markets—
stocks, futures, currency, bonds—would take the change in stride, maybe
with stocks cooling off slightly and the dollar strengthening. I kept calling
back to the office to check how the markets were responding.
The sky did not catch fire that day. Stocks dipped, banks upped their
prime lending rates in line with our move, and the financial world, as we'd
hoped, noted that the Fed had begun acting to quell inflation. Perhaps the
most dramatic impact was reflected in a New York Times headline a few
days later: "Wall Street's Sharpest Rise: Anxiety." I was finally allowing
myself to breathe a sigh of relief when a message reached me from Paul
Volcker. He knew exactly what I'd been going through. "Congratulations,"
it read. "You are now a central banker."
I did not for a minute think we were out of the woods. Signs of trouble
in the economy continued to mount. Slowing growth and a further weakening
of the dollar put Wall Street on edge, as investors and institutions began
confronting the likelihood that billions of dollars in speculative bets would
never pay off. In early October, that fear turned to near panic. The stock
market skidded, by 6 percent the first week, then another 12 percent the
second week. The worst loss was on Friday, October 16, when the Dow
Jones average dropped by 108 points. Since the end of September nearly
half a trillion dollars of paper wealth had evaporated in the stock market
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alone—not to mention the losses in currency and other markets. The decline
was so stunning that Time magazine devoted two full pages to the stock
market that week under the headline "Wall Street's October Massacre."
I knew that from a historical perspective this "correction" was not nearly
the most severe. The market slump in 1970 had been proportionally twice
as large, and the Great Depression had wiped out fully 80 percent of the
market's value. But given how poorly the week had ended, everyone was
worried about what might happen when the markets opened again on
Monday.
I was supposed to fly on Monday afternoon to Dallas, where on Tuesday
I was to speak at the American Bankers' Association convention—my
first major speech as chairman. Monday morning I conferred with the
Board of Governors, and we agreed that I should make the trip, lest it seem
that the Fed was in a panic. The market that morning opened weakly, and
by the time I had to leave it looked awful—down by more than 200 points.
There was no telephone on the airplane. So the first thing I did when I arrived
was to ask one of the people who greeted me from the Federal Reserve
Bank of Dallas, "How did the stock market finally go?"
He said, "It was down five oh eight."
Usually when someone says "five oh eight," he means 5.08. So the market
had dropped only 5 points. "Great," I said, "what a terrific rally." But as
I said it, I saw that the expression on his face was not shared relief. In fact,
the market had crashed by 508 points—a 22.5 percent drop, the biggest
one-day loss in history, bigger even than the one on the day that started the
Great Depression, Black Friday 1929.
I went straight to the hotel, where I stayed on the phone into the night.
Manley Johnson, the vice chairman of the Fed's Board, had set up a crisis
desk in my office in Washington, and we held a series of calls and teleconferences
to map out plans. Gerry Corrigan filled me in on conversations
he'd had in New York with Wall Street executives and officials at the stock
exchange; Si Keehn had talked to the heads of the Chicago commodities
futures exchanges and trading firms; Bob Parry in San Francisco reported
what he was hearing from the chiefs of the savings and loan industry, who
were mainly based on the West Coast.
The Fed's job during a stock-market panic is to ward off financial
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paralysis—a chaotic state in which businesses and banks stop making the
payments they owe each other and the economy grinds to a halt. To the senior
people on the phone with me that night, the urgency and gravity of
the situation was apparent—even if the markets got no worse, the system
would be reeling for weeks. We started exploring ways we might have to
supply liquidity if major institutions ran short of cash. Not all of our younger
people understood the seriousness of the crisis, however. As we discussed
what public statement the Fed should make, one of them suggested, "Maybe
we're overreacting. Why not wait a few days and see what happens?"
Though I was new at this job, I'd been a student of financial history for
too long to think that made any sense. It was the one moment I spoke
sharply to anybody that night. "We don't need to wait to see what happens,"
I told him. "We know what's going to happen." Then I backed up a
little and explained. "You know what people say about getting shot? You
feel like you've been punched, but the trauma is such that you don't feel
the pain right away? In twenty-four or forty-eight hours, we're going to be
feeling a lot of pain."
As the discussion ended, it was clear that the next day would be full of
major decisions. Gerry Corrigan made a point of telling me solemnly, "Alan,
you're it. The whole thing is on your shoulders." Gerry is a tough character
and I couldn't tell whether he meant this as encouragement or as a challenge
for the new chairman. I merely said, "Thank you, Dr. Corrigan."
I was not inclined to panic, because I understood the nature of the
problems we would face. Still, when I hung up the phone around midnight,
I wondered if I'd be able to sleep. That would be the real test. "Now we're
going to see what you're made of," I told myself. I went to bed, and, I'm
proud to say, I slept for a good five hours.
Early the next morning, as we were honing the language of the Fed's
public statement, the hotel operator interrupted with a call from the White
House. It was Howard Baker, President Reagan's chief of staff. Having
known Howard a long time, I acted as though nothing unusual were going
on. "Good morning, Senator," I said. "What can I do for you?" "Help!" he said
in mock plaintiveness. "Where are you?"
"In Dallas," I said. "Is something bothering you?" Handling the administration's
response to a Wall Street crisis is normally the job of the treasury
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secretary. But Jim Baker was in Europe trying to make his way back; and
Howard didn't want to deal with this one on his own. I agreed to cancel my
speech and return to Washington—I'd been inclined to do so anyway, because
in light of the 508-point market drop, going back seemed the best
way to assure the bankers that the Fed was taking matters seriously. Baker
