Learning about Policy from Federal Reserve History

The United States is the world's main monetary power. The Federal Reserve presided over the transition from a local or regional system of financial institutions to the current leader of the world monetary system. It managed the transition from the gold standard through several alternatives to the present system, or non-system, of floating rates for principal currencies. It managed the transition from a monetary arrangement based on member bank borrowing and the real bills doctrine to the present system based on open market operations supposedly directed at the dual mandate. Traditional central bank secrecy proved incompatible with democratic openness, so the Federal Reserve has learned to be more open about its operations and now concerns itself with communications policy. In its 96 years, it has remained free of major scandal. And, from the 1920s on it has done pioneering research on monetary policy and has built not one, but many, dedicated and highly qualified research staffs at the Board and several of the regional banks.

After the mistakes that produced the Great Inflation, the Federal Reserve achieved the "great moderation." From the mid-1980s to about 2005, the U.S. experienced a long period of stable growth, low inflation, and short, mild recessions. These years are the best in Federal Reserve history. Unfortunately, the System did not continue the policies that achieved its greatest success.

Errors such as the failure to urge auctions of Treasury security offerings, or the greater weight given to unemployment than to inflation, or the use of four percent as the full employment rate long after that rate rose, reflect both error and political pressure.

On the opposite side of the ledger are major and minor mistakes, many of which were repeated. Some members recognized most and perhaps all of the main errors. The FOMC minutes record all the main criticisms that I make followed by my comment saying there was no response and no discussion. Recognition by FOMC members implies that at least some of the errors could have been prevented.

Reflecting convictions held by many in Congress and in several administrations Federal Reserve policy gave greatest attention to avoiding unemployment. It usually followed a lexicographic ordering that gave priority to employment. After most countries in Western Europe restored currency convertibility for current accounts, the conflict between the goals of the Employment Act and Bretton Woods became apparent. The Federal Reserve treated the exchange rate as a secondary or tertiary consideration, mainly a problem for the Treasury. Its main error was to diligently pursue an agreement to expand world reserves (the Triffin problem) and ignore the more pressing issue of real exchange rate adjustment. In this, it cooperated with the Treasury.

Errors such as the failure to urge auctions of Treasury security offerings, or the greater weight given to unemployment than to inflation, or the use of four percent as the full employment rate long after that rate rose, reflect both error and political pressure. Economists often treat monetary policy as not affected by politics. Models of optimal monetary policy have no role for politics. Perhaps they take this position because they equate Federal Reserve independence with freedom to take action and follow any chosen path. Alas, that is rarely true. The changing meaning of "independence" is one theme of my history.

This paper is available as an Adobe Acrobat PDF.

Allan H. Meltzer is a visiting scholar at AEI.

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