A History of the Federal Reserve, Volume 2 (4 page)

Second, abundant econometric evidence suggests strongly that prices of long-dated assets have separate roles in the transmission of monetary policy. Considerable research shows that expectations theory of the term structure of interest rates does not hold at times. The relation of long- to short-term rates changes. The same is true of other asset prices and especially exchange rates. One reason is the market’s inability to estimate the term premium accurately. Different procedures give different estimates, often considerably different.

Woodford (2005, 886–87) recognizes that long-term rates contain information useful to the Federal Reserve in interpreting its policy, but he concludes that a central bank could not affect the economy by purchasing long-term bonds even when the short-term rate is zero. The experience of the Bank of Japan after 2002 and on several occasions in U.S. history supports the opposite conclusion; expanding base money and money by purchasing longer-term securities stimulated spending with a zero shortterm interest rate. Blinder (2004, 77) concluded that “the implied interest rate forecasts (expectations) that can be deduced from the yield curve bear little resemblance to what future interest rates actually turn out to be. . . . Suffice it to say that the abject empirical failure of the expectations theory of the term structure of interest rates is a well-established fact.”

The distinction between sustained rates of change and changes in the price level is important for the term structure. Devaluation or an oil price increase raises the reported price level. If the increased oil price is expected to remain, the effect on interest rates is mainly at the short end. An increase in inflation expected to be sustained raises rates along the entire term structure.

Third, to use the Woodford model, central bankers require reliable estimates of potential output and expected inflation. Research has shown that economists do not have such estimates and to date have not developed reliable estimates. This was a main reason for the large errors in predicting inflation in the 1970s, as Orphanides (2001) showed. And it is a main weakness of Phillips curve predictions of inflation and Woodford’s model.

Role
of
Government

Monetarists and Keynesians held different visions of the role of the government and the private sector. Following Keynes (1936), Keynesians viewed the private sector of the economy as unstable, subject to waves of optimism or pessimism that produced economic booms and recessions. Government had to act as a stabilizer, at first by changing its expenditures and tax rates and later by adjusting interest rates.

Monetarists hold a contrary view. The internal dynamics of the private sector are stabilizing. Relative prices adjust to restore equilibrium. Declining tax collections and increased spending in recessions, built-in stabilizers, support recovery. Adjustment is not instantaneous, so government policy can nudge the economy toward equilibrium, but too often government policy worsens outcomes by doing too much or too little.

A standard monetarist complaint about the Federal Reserve from the 1950s to the 1970s was that it misinterpreted its own policy. When shortterm interest rates declined, the Federal Reserve interpreted the decline as easier policy despite a decline in money growth. And it interpreted an increase in interest rates as evidence of more restrictive policy even if money growth increased. Failure to distinguish between real and nominal interest rates until the late 1970s was part of the problem, but not the whole problem. Until 1994, monetary policy was typically procyclical until late in the inflation or recession.
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The most damaging effect of the Keynesian belief in the role of government came after 1960. Administration economists argued that inflation would increase before the economy reached full employment output. Government had the role of limiting wage and price increases using guideposts and guidelines. This approach to pricing interfered in private decisions and, if successful, would have restricted prices and wages from reallocating resources efficiently. It concentrated attention on pricing in visible sub-sectors, especially those with strong unions. And it focused on price changes in those industries instead of general inflation.

Keynesian economists and policymakers repeated this claim but did not produce evidence to support it. After 1980, the Federal Reserve abandoned the claim and insisted instead that stable low inflation abetted economic expansion and high employment. After inflation declined, the United States experienced three long peacetime expansions punctuated by relatively mild recessions. Low, relatively stable inflation contributed to this outcome. Researchers differ on the degree.

Some monetarist analysis included a credit or financial market (Brunner and Meltzer, 1989, 1993, and 1968). This analysis recognized that money, government debt, and real capital are distinct assets held in portfolios. One function of financial markets is to allocate the stock of debt between banks and the public. This process is a factor in the determination of
asset prices and interest rates. Recent work by Goodfriend and McCallum (2007) returns to issues involving intermediation and financial markets.

12. Monetarists erred by insisting too strongly on direct control of money growth instead of an interest rate. Experience since 1994 shows that the Federal Reserve learned to adjust the interest rate counter-cyclically. The German Bundesbank and the European Central Bank use money growth as a “second pillar,” that is, as an indicator of whether the interest rate is set appropriately.

Summary
on
Theory
and
Policy

The two-way relation between monetary theory and policy was never complete or precise. The Federal Reserve and other central banks became more professional as time passed and complexity increased. Economists with academic training and experience occupied leading roles at central banks. Much larger staffs and more policymakers came from academic backgrounds. No chairman of the Board of Governors came from a professional economics background before 1970. After 1970 all but one had that training and experience. Nevertheless, analytic errors and misjudgments had a large role in mistaken policy choices.

Cagan (1978a, 85–86) described the early postwar consensus on the role of money. “The quantity theory of money was not considered important, indeed was hardly worth mentioning, for questions of aggregate demand, unemployment, and even inflation . . . [I]f you traveled among the profession at large, mention of the quantity of money elicited puzzled glances of disbelief or sly smiles of condescension.”

For very different reasons, the Federal Reserve ignored money growth until the mid-1970s, when Congress, over Arthur Burns’s objections, required semiannual statements that included ranges for money growth consistent with administration economic policy. William McChesney Martin, Jr., chairman from 1951 to 1970, had no interest in economic theory and did not find it useful. Until very late in his chairmanship, he prevented his staff from making forecasts. He often said that he did not understand statistics on money growth. He opposed attempts to control inflation by controlling money growth. In 1969, he replied to Milton Friedman, saying: “I seriously doubt that we could ever attain complete control [of monetary aggregates], but I think it’s quite true that we could come significantly closer to such control than we do now—if we wished to make that variable our exclusive target. But the wisdom of such an exclusive orientation for money policy is, of course, the basic question” (quoted in Friedman, 1982, 106).
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Except for control of money, monetarist arguments prevailed eventually. The Phillips curve tradeoff vanished in the long run, as Friedman (1968b) predicted. Policy distinguished real and nominal interest rates and exchange rates. Long-run neutrality of money again became standard
in economic theory. Strangely, models incorporating these ideas are now called neo-Keynesian (Ball and Mankiw, 1994).

13. Friedman commented that Martin’s response recognized that the Federal Reserve could control money growth, contrary to many earlier statements.

Romer and Romer (1994, 56–57) concluded their study of postwar macroeconomic policy by finding that “monetary policy alone is a sufficiently powerful and flexible tool to end recessions.” Contrary to the early Keynesian position, they found that “fiscal actions contributed only moderately to recoveries . . . [T]he historical record contradicts the view that fiscal policy is essential to ending recessions or ensuring strong recoveries.” However, the authors found that frequently monetary policy was destabilizing, and procyclical instead of counter-cyclical. This was a main monetarist criticism from the 1960s on.

McCallum (1986) reviewed discussion of monetary and fiscal policy and critiqued criticisms of the Andersen and Jordan (1968) findings showing the relative and absolute importance of monetary policy for output. He concluded (McCallum, 1986, 23) that “an open-market increase in the money stock has a stimulative effect on aggregate demand.” This conclusion would not be remarkable if it had not been denied by early Keynesians and challenged by critics of the Andersen-Jordan paper.

Modigliani’s (1977) conclusion that the monetarist position was correct on main issues of theory and fact represents an end to the controversy. He did not accept a monetary rule, and neither has the economics profession. Central banks continue to target interest rates, but they give much greater weight to avoiding inflation and damping inflationary expectations.

Central
Bank
Independence

Interpretations of central bank independence have changed several times. The changes were not limited to the United States. At the end of World War II, the British Labor government nationalized the Bank of England and made it subservient to the Treasury, that is to the elected government. Fifty years later, a new Labor government made the Bank independent. The Bank and the government now agree on an inflation target. With few restrictions, the Bank is empowered to decide on its actions. After years of inflation and slow growth, the government accepted the importance of price stability for economic growth and the importance of independence for price stability.

The European Central Bank (ECB) requires governments to accept the independence of its member central banks. The ECB’s legal mandate is price stability, interpreted to mean sustained low inflation.
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Governments
and ministers complain about the ECB’s actions, but they have not changed its mandate. Change requires unanimous agreement.

14. Article 108 of the Maastricht treaty says: “Neither the ECB [European Central Bank] nor a national central bank . . . shall seek or take instructions from community institutions or
bodies, from any government of a Member State or from any other body.” This article restricts political influence in a way that U.S. law doe
s not.

The Federal Reserve Act gave the System independence that with few exceptions, as in wartime, administrations accepted until 1933. From 1933 to 1951, the Treasury Department dominated the Federal Reserve’s decisions, at first by direct pressure and in World War II and thereafter by agreement.
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Slowly after March 1951, the Federal Reserve regained some independence, but it remained responsible for assuring the success of Treasury debt sales. From 1961 to 1979, policy coordination, the emphasis given to avoiding recessions, and frequent Treasury debt sales restricted independence. The System gained increased independence for disinflation starting in 1979, and it retained its independence during the next quarter century. Testifying before a House subcommittee in 1989, Chairman Greenspan described independence as necessary to enable the central bank “to resist short-term inflationary biases that might be inherent in some aspects of the political process” (Greenspan, 1989, 2). Regrettably, the record does not show either a consistent avoidance of short-term pressures or avoidance of inflationary pressures from elected officials.
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Cukierman (2006, 149) points out the difficulty of not knowing the value of potential output as a source of error, possibly large error, in achieving an inflation target while maintaining actual output close to potential output. Orphanides (2003a,b) demonstrated the relevance of this point.

Independence is never absolute.
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There are two principal, formal restrictions in the United States. First, the Federal Reserve is the agent of Congress. The Constitution gives Congress authority to “coin money [and] regulate the value thereof”; in principle, Congress can withdraw the authority or restrict Federal Reserve actions. On occasion, it has discussed such restrictions and in the 1970s, Congress required the Federal Reserve to report on
its actions and plans. Second, the Treasury is responsible for international economic policy decisions. It can adopt a fixed exchange rate, requiring the Federal Reserve to intervene in the exchange market and to adjust interest rates and money growth consistent with the exchange rate target. On occasion, as in mid-1980s, the Treasury can agree on an exchange rate target, but the independent Federal Reserve sterilized most Treasury intervention. Table 1.1 above shows that it did not give priority t
o the exchange rate.

15. Marriner Eccles, chairman from 1934 to 1948, defined independence as “the opportunity to express its views in connection with the determination of policy” (Board Minutes, February 3, 1942, 8). See Meltzer (2003, 599, n. 27).

16. Former vice chairman Alan Blinder is a bit more explicit. “Central bank independence means two things: first, that the central bank has freedom to decide how to pursue its goals and, second, that its decisions are very hard for any other branch of government to reverse” Blinder (1998, 54). This leaves two critical issues open. First, does the central bank coordinate its policy with the administration so that it “independently” decides to finance the budget deficit? Second, how free is the central bank to choose its objectives? Does it have a broad mandate like the so-called dual mandate or does the administration choose the inflation target. The Federal Reserve is always concerned that Congress can restrict its independence.

17. Cukierman, Webb, and Neyapati (1992) discuss the problem of measuring independence in developed and developing countries.