A History of the Federal Reserve, Volume 2 (8 page)

Volcker was an anti-inflationist and a “practical monetarist.” Within two months of becoming chairman, he convinced the FOMC that it had to control money growth and allow interest rates to move as much as required to slow inflation.

Volcker restored Federal Reserve independence and made a major change in its policy views. Instead of the belief that the economy required guidelines to reconcile low inflation and low unemployment, Volcker claimed that low inflation would encourage expansion and employment. The Federal Reserve’s goal changed to reducing inflation.

Chapter 8 discusses policy actions from 1979 to 1982. With strong support from President Reagan and principal members of Congress, inflation fell to 4 percent by the end of 1982. The unemployment rate rose above 10 percent by fall 1982. A high unemployment rate, credit difficulties in the banking system caused by defaults on foreign loans, and congressional pressure brought a change in monetary policy in the summer and fall of 1982. The Federal Reserve returned to control of member bank borrowing and gave up efforts to control money growth. But it did not return to an inflationary policy.

The so-called experiment with monetary control is generally regarded as a failure. The experiment was never complete; the FOMC considered but did not adopt institutional changes that would have improved its ability to control money growth. Also, large changes in the public’s asset allocation followed after Congress deregulated banking and financial markets. These changes made it difficult to interpret changes in monetary aggregates during the transition to a less regulated system.

Volcker distrusted forecasts and relied more on his judgment and interpretation than on economic models. His “practical monetarism” did not go much beyond a belief that money growth above output growth was a necessary condition for inflation. His courage and determination to lower inflation showed in his willingness to raise interest rates despite relatively high and rising unemployment.

Chapter 9 discusses actions taken from 1982 through 1986. Expectations of inflation as reflected in long-term interest rates and exchange rates (Charts 1.4 and 1.7 above) declined slowly. I date the end of the inflation in 1986, when the public seemed to accept that high inflation would not return soon.

Chairman Volcker and the FOMC did not follow any explicit economic theory. Volcker relied on his assessment of events and his guesses about
the future. He gave most attention to member bank borrowing, and he denied that he used an interest rate target. The FOMC was more alert to inflation than in the 1960s and 1970s.

Chapter 10 concludes the volume. Federal Reserve policy remained much better than earlier until the mid-2000s. The economy experienced three long expansions followed by two relatively mild recessions. Variability of output and inflation declined; many called it “the great moderation.”

I suggest some changes to improve monetary policy further. Although efforts to focus on longer-term objectives have been made, more needs to be done. The Federal Reserve needs to announce two strategies—one to guide its monetary policy operations, the other to guide its operations as lender of last resort. And it must insist on maintaining independence.

The history of an institution is a record of successes and failures. I have suggested principal reasons for the failures—the inability to agree on a broad framework for analyzing events, a failure to focus on medium- to long-term outcomes, and the difficulty or inability to resist political pressures much of the time. At the time of its creation, proponents and opponents recognized a principal issue: Would the Federal Reserve be controlled by bankers operating in their interest or by politicians operating in theirs? Over time, control shifted to the Board of Governors. Resistance to political influences often weakened. Insistence on independence from political pressures was not impossible but required more courage than was usually present.

two

A New Beginning, 1951–60

You certainly have the advantage over me of being closer to the market, but it may not be an unmixed advantage. The ticker may loom too large in your perspective and what from the point of view of the national economy are molehills may . . . appear to you as mighty mountains.

—Letter, Viner to Sproul, in Sproul papers, Correspondence, S–W 1940–1955,
January 9, 1948

The March 1951 Accord with the Treasury opened a new era in Federal Reserve history. Once again, the Federal Reserve could claim to be independent, as its founders intended. It could raise interest rates without prior approval or consultation with the Treasury, at first only within the transitional limits set for the year by the Accord.
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The new arrangement reopened issues that had remained dormant. What did independence mean in practice? What goals should an independent central bank pursue? How could it reconcile independence with continued responsibility for the success of Treasury debt management operations? By what means could it efficiently achieve its goals? What guiding
principles should govern practice? How should it organize and operate to carry out its functions?

1. Volume 1, chapter 7 discusses the details of the Treasury–Federal Reserve Accord of March 1951. The Accord ended a nine-year period during which the Federal Reserve consulted the Treasury before changing interest rates. In practice, the Treasury exercised a veto over interest rate changes. The Accord permitted the Federal Reserve to let the rate on longterm government bonds exceed 2.5 percent and let short-term rates rise to the discount rate. The Federal Reserve agreed to maintain orderly markets and shared responsibility for success of debt management operations with the Treasury. In practice this responsibility led the Federal Reserve to adopt an “even keel” policy of maintaining interest rates during periods of Treasury borrowing. This permitted money growth to increase especially when budget deficits rose in the late 1960s. The remaining provisions are in volume 1, 711–12.

The Federal Reserve had not faced these issues since the 1920s. The Federal Reserve Act, as amended and amplified by other legislation, left much scope for interpretation. The old procedures developed under the gold exchange standard reflected very different organizational and economic arrangements. The Banking Act of 1935 shifted power from the federal reserve banks to the Board of Governors, eliminated the semiautonomous nature of the reserve banks and moved control of open market operations from the reserve banks to an open market committee on which the Board had seven of twelve votes. It did little to clarify the system’s mandate. The 1944 Bretton Woods Agreement established a fixed but adjustable exchange rate regime, although most currencies other than the dollar remained inconvertible until 1959. The United States’ relatively large stock of gold was more than ample to satisfy any likely demand at the time, and, in truth, administration policy favored some redistribution of foreign exchange and gold holdings abroad. Of greatest importance subsequently, the Employment Act of 1946 committed the country to maximum employment and purchasing power but did not further define these terms. When passing the Employment Act, Congress did not explain how to reconcile its domestic employment goal with the Bretton Woods Agreement and with the political and military obligations the United States soon accepted as part of the cold war with the Soviet Union and its allies.

Domestic policy dominated international concerns during most of this period. The Federal Reserve recognized that international economic policy was principally a Treasury function, not their primary responsibility.

Under the Employment Act, Congress expected the Federal Reserve to do more than avoid another Great Depression. It expected the act to lower the average and variability of the unemployment rate, and for many years it gave much greater weight to unemployment than to inflation. The new emphasis on employment heightened congressional interest in what the Federal Reserve did, in how and why it made its decisions. Increased frequency of congressional hearings reflected this political interest. Later, rising pressure for policy coordination with the administration challenged the Federal Reserve to find ways of reconciling independence and coordination. It did not succeed.

Near the end of World War II, the Federal Reserve had engaged in domestic postwar planning, but it had not directly addressed or anticipated some of these issues. Its main concern was to avoid a return to the depressed high-unemployment economy of the 1930s. By 1951, with the Korean War under way, these concerns were no longer paramount. Its concern was re
surgent wartime inflation. In the words of one of its principals: “Up to the time of the Korean crisis, the Federal Reserve was content to carry on a holding operation. It joined with the Treasury in opposing those who . . . counseled abrupt and vigorous use of credit policy to reduce the swollen money supply . . . In the face of the economic repercussions of the Korean crisis, however, such an approach was no longer practical” (Sproul, 1964, 234).

At first, the Federal Reserve made no effort to set objectives for employment and inflation or develop the means of achieving them. It began its independent operation about where it had left off in the 1920s. Minutes of meetings show that the System’s principal concern was with current money market conditions, mainly control of the volume of member bank borrowing. By controlling borrowing, it expected to influence the banks’ supply of credit and thus the pace of economic activity. If this were done properly, officials and staff expected the price level to fluctuate around some stable value, but they did not have a framework linking their actions to these objectives, and they made no effort to develop one.

Reversion to the practices of the 1920s is not entirely surprising. The new chairman of the Board of Governors, William McChesney Martin, Jr., was the son of a former Federal Reserve official. His father had served first as Chairman, later as governor and president of the St. Louis Federal reserve bank from 1914 to 1941. Martin reactivated the 1920s procedures with assistance from two staff members who served in the 1920s— Winfield Riefler and Woodlief Thomas. Riefler was assistant to the chairman and later Secretary of the Federal Open Market Committee. Thomas was research director and, after 1949, adviser to the Board.
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The structure of the modern Federal Reserve is, in large part, Martin’s creation. In the 1950s especially, he restructured the open market committee and its operating procedures. Shortly after coming to the Federal Reserve, he chaired a committee that recommended changes in the relation of the Federal Open Market Committee (FOMC) to the manager of the System account, the type of securities purchased, and the frequency of FOMC meetings. By 1955, the FOMC had adopted a policy of purchasing only Treasury bills (except in crises), eliminated the Executive Committee, greatly increased the frequency of its meetings, expanded the scope of its deliberations to include not just open market operations but all the tools of monetary policy, and encouraged all FOMC members to contribute to the policy discussion.

2. Riefler joined the Board’s staff in 1923. In 1933, he left the staff but returned in 1948 as assistant to the chairman and secretary of the open market committee. During 1941–42, he served as a director of the Philadelphia Reserve Bank. He retired at the end of 1959. Thomas left the staff from 1928 to 1934. He retired in 1966.

The 1950s were a period of experimentation and eclecticism. The System did not develop a broad policy framework to replace the analysis in the Tenth Annual Report of 1923. The Riefler-Burgess version of the real bills doctrine, inherited from the 1920s, soon faded away, leaving some traces behind. This notion emphasized the quality of credit as a way of controlling inflation. Real bills called for the discounting of productive credit to finance agricultural, commercial, and industrial concerns and for avoidance of speculative credit. The heightened role of open market operations and the reduced role of discounting could not be reconciled with the real bills doctrine. No single framework replaced real bills. Initially, the FOMC gave the manager qualitative guidance, characterized by imprecise directions such as “achieve slightly more ease (restraint),” “promote active ease,” “respond to tone and feel,” or “lean on the side of restraint.” The main target was free reserves—excess reserves minus member bank borrowing—but members often did not agree on a specific range. Some members chafed at the imprecision of the FOMC directives and the autonomy left to the manager, but the directives remained imprecise.

The new arrangements were in some ways a replay of the early 1930s, when the Board expanded membership of the open market committee to reduce New York’s influence. Martin’s actions shifted influence away from Allan Sproul, president ofthe New York Reserve Bank until 1956. By eliminating the five-person Executive Committee, which Sproul dominated, he reduced Sproul’s power; by restricting purchases to bills, he limited New York’s discretion; by requiring all members of the FOMC to state their opinions and make choices, he diluted New York’s influence. The long struggle between New York and Washington faded away. By the mid-1950s or thereabouts, Washington controlled the System.

In the 1920s, the Federal Reserve tried to control the level of member bank borrowing. It assumed that excess reserves remained constant. Recognition that excess reserves could change, as they did in the 1930s, shifted attention to free reserves, excess reserves minus borrowing. In the Federal Reserve’s analysis, an increase in free reserves eased the money market; a reduction tightened the market. The new measure, like the old, carried the implication that increased member bank borrowing tightened the money market (and Federal Reserve policy) despite the increase in reserves and the monetary base that banks in the aggregate obtained by borrowing. This reasoning probably reflected the use of borrowing or free reserve targets as an imperfect substitute for an interest rate target. Since borrowing increased total reserves and the monetary base, other things being equal, increased money accompanied the increase in borrowing.

The free reserve framework failed to recognize that, at any level of free
reserves or borrowing, policy could be lax or restrictive depending on what happened to the growth of money or credit. Although the minutes contain references to money growth, it remained in the background at FOMC meetings. Many members believed that, in the long run, excessive money growth caused inflation, but long-term considerations of this kind received less attention than short-term events reflecting both long-standing practices and Chairman Martin’s lack of interest in statistics and in forecasts or projections of more distant concerns. Until the mid-1960s, the Federal Reserve operated under the Riefler rule; it did not make or discuss forecasts. Frequent meetings and the Riefler rule concentrated attention on current events.