A History of the Federal Reserve, Volume 2 (131 page)

Analytic errors contributed to inflationary policy. Bad analysis and flawed theoretical understanding can lead to major policy mistakes, as in the Great Depression. The Federal Reserve policymakers made no effort to achieve analytic clarity on such basic issues as the causes of inflation. Several of its members doubted that it was worth the effort. They did not respond to Darryl Francis’s efforts to explain that (1) in the long run, inflation was caused by money growth in excess of real growth, and (2) Federal Reserve policy produced excess money growth because it did not permit interest rates to increase enough. Similarly, they did not respond positively to Sherman Maisel’s efforts to adopt a consistent policy framework.

Inaccurate forecasts added to the control problem. Chart 4.17 suggests that the Board’s forecasts remained close to forecasts by the Society of Professional Forecasters. Both forecasts rarely overestimated inflation, but the underestimates are large and later highly persistent. Orphanides (2003a, 2003c) emphasized this error. The members of FOMC were aware that errors were made, and they attempted to correct or reduce the errors and the rate of inflation by giving more attention to money growth. But until
1979 or 1980 they remained as a group reluctant to let unemployment rise enough to reduce inflation permanently.

Inaccurate forecasts, mistaken beliefs, lack of a coherent framework, and the absence of agreement on an analytical framework all played a role. But criticism of these errors were made frequently and usually without effect. Missing from most explanations by economists is the political dimension. By law the Federal Reserve was an independent agency. In practice, it responded to political pressures to coordinate policy by financing deficits and giving primacy to reducing the unemployment rate and the impact of restrictive policy on home building.

Three morals stand out: you cannot end inflation (1) if you don’t agree on how to do it; (2) if you and the public think it is less costly to let it continue; and (3) if you are overly influenced by politics. The Federal Reserve was better able to control inflation when the president was named Eisenhower or Reagan than when he was named Johnson, Nixon, or Carter. Book 2 of this volume contrasts the 1970s and the 1980s. The Federal Reserve sacrificed its independence in the 1970s by acting on the mistaken belief that it could avoid recessions by increasing inflation. When it reasserted its independence in 1979, many of its problems continued. It still lacked a coherent framework; it did not develop a common approach to analyzing the economy; it did not separate temporary from persistent changes. The most important change was a willingness to accept increased unemployment and to persist in a policy of reducing inflation. The economy suffered a deep
recession, but inflation fell to low levels, and markets gradually became convinced that the Federal Reserve would persist in its disinflation policy.

Chapters 5 through 10, in book 2 of this volume, trace the mistaken and unsuccessful policies of the 1970s that ended in the Volcker disinflation.

APPENDIX TO CHAPTER 4

Chart 4A.1 shows the monetary base, its principal sources and the interrelation of the sources based on a vector autoregression (VAR) with two lags and eleven seasonal dummy variables. The VAR has four variables entered in the following order: discounts, gold, base, and government securities held by the reserve banks. Data are monthly from January 1961 to September 1971, the period discussed in chapters 3 through 5.

The chart offers a st
atistical analysis of
the policy actions d
iscussed in the text.
It replicates for th
e 1960s the statistic
al analysis for the 1950s
and 1920s in the appendix to chapter 2 of this volume and chapter 4 of volume 1.

Many of the statistical findings reflect a common source. The FOMC or the manager controlled free reserves or short-term interest rates. Any disturbance that changed interest rates induced offsetting actions. The gold outflows raised interest rates, inducing member bank discounts and open market purchases. Similarly, as discounts increased, the manager purchased fewer government securities.

Unlike the 1920s, when gold flow and discounts dominated changes in the base, the base responded mainly to open market purchases in the 1960s as in the 1950s. Gold movements had no significant effects on the base in this decade, but the components of the base—discounts and government securities—increased modestly as the gold stock fell. This is a change from the 1950s.