An episodic history of modern fed independence.

Author:Smith, Daniel J.
Position:Federal Reserve Board

The Congress established the Federal Reserve, set its monetary policy objectives, and provided it with operational independence to pursue those objectives. The Federal Reserve's operational independence is critical, as it allows the [Federal Open Market Committee] to make monetary policy decisions based solely on the longer-term needs of the economy, not in response to short-term political pressures.

--Ben S. Bernanke, Semiannual Monetary Policy Report to the Congress (2011)

This paper contextualizes, supports, and informs previous empirical studies on the independence of the Federal Reserve (Fed) with an episodic history of modern Fed independence. At the Fed's founding, its independence was considered necessary to separate monetary policy from the influence of electorally focused politicians and special-interest groups (Kettl 1986, 3; Morris 2002, 4-5; Bernanke 2010a). According to C. W. Barron, at its founding, Fed independence meant that "[i]f the new Federal Reserve Board is of the desired quality and character it will be the most unpopular board that ever sat in Washington. It will turn deaf ears to all political and sectional considerations. The greater the clamor for cheap money the tighter it will hold the reserves" (1914, 13).

With these concerns in mind, the structure of the Fed was designed to turn "monetary policy over to a small group of people selected so as to balance the interests for and against inflation" (Faust 1996, 268). Although the Fed is an agency of Congress and responsible to Congress, the need for an independent Fed to "make monetary policy independently of short-term political influence" (Bernanke 2010a) has been recognized since the Fed's inception.

Despite early efforts to create an independent Fed, its independence was quickly undermined during the tumultuous political and economic periods of World War I, the Great Depression, and World War II (Flavrilesky 1995b; Meltzer 2003). Some economists hold that structural tweaks and greater transparency have ensured, according to Ben Bernanke, that the "effective degree of independence [at the Fed] has gradually increased over time" (2010a). However, empirical studies measuring the degree of Fed independence have found, even in modern times, evidence of substantially compromised Fed independence (Boettke and Smith 2013).

This paper seeks to understand how the modern Fed, despite the many steps taken since its founding to ensure independence, still succumbs to political influence. We examine the postwar period to focus on the modern Fed's independence following the 1951 Accord between the U.S. Department of the Treasury and the Fed, which, according to Robert Hetzel and Ralph Leach, "marked the start of the modern Federal Reserve System" (2001b, 53-54). Michael Munger and Brian Roberts also indicate that following the 1951 Accord the Fed had a mandate to "lean against the wind, implying an unprecedented discretionary choice of how much monetary growth was too much, and how little was too little" (1993, 90). Our episodic history finds that even an increasingly sheltered Fed, primarily under the control of economists with increasingly refined monetary models, has failed to remain independent of political pressures. Although the Fed has at times been able to assert its independence, it is clear that at times it has also succumbed to political pressure.

We use an anecdotal approach to supplement the existing empirical approaches because, as David Meiselman argues, "a convincing test or proof may require more detailed and explicit information about explicit intentions on a more micro level, including who said and did what to whom" (1986, 571, emphasis in original) and, as Kevin Grier stresses, "No amount of regression analysis can ever prove that the Fed is politically controlled" (1987, 481; see also Grier 1989, 388). Historical context is necessary to supplement the existing empirical investigations to understand when these separate influences were operational and the mechanism of their operation. Anecdotal work, such as our episodic history, can corroborate the existing empirical literature and inform future empirical investigations. (1)

We analyze the history of modern Fed independence by the tenure of each Fed chairperson, starting with William Martin and ending with Ben Bernanke. Even these modern Fed chairs, utilizing refined economic models and bolstered by modern structural tweaks and greater transparency, have succumbed to political pressures in different ways and to varying degrees.

William Martin (1951-1970)

William Martin was appointed chairperson of the Fed in 1951 by President Harry Truman after he played an important role in negotiating the 1951 Accord as the assistant secretary of the Treasury. Under Martin, the role of the modern Fed came to be one of macroeconomic stabilization (his famous "leaning against the wind" policies) and price-level stability (Hetzel and Leach 2001a, 2001b). However, even with its newfound independence from the Treasury, for the Fed under Martin

[independence no longer excluded consultations and exchange of information. Martin's interpretation of the 1951 Accord went further. He [Martin], and most others in the System, believed that the Federal Reserve had a responsibility to assure that Treasury bond issues did not fail. He reasoned that Congress voted the budget that the Treasury had to finance. The Federal Reserve had an obligation to help make the issues succeed in the market, provided the Treasury priced its issues at market rates. It should not refuse to accept the fiscal decision or refuse to assist in financing. Help took two forms: preventing failure of new issues and refundings, and maintaining even keel policy during Treasury operations. Even keel meant that the Federal Reserve supplied enough reserves to permit banks to purchase their share of the issue. This seems a narrow meaning of independence. When budget deficits became large and frequent, independence was severely restricted. (Meltzer 2009a, 261)

Martin was reportedly under some pressure to provide accommodating monetary policy throughout the 1950s (Havrilesky 1995b, 54) and met frequently with President Dwight Eisenhower, the Treasury secretary, and the chairperson of the Council of Economic Advisors (CEA) to discuss the economy (Bach 1971, 91; Meltzer 2009a, 261).

In the 1953-54 recession, Eisenhower, to ensure that he fulfilled a 1952 campaign pledge that he would prevent another depression, wrote in his diary that he "talked to the secretary of the Treasury in order to develop real pressure on the Federal Reserve Board for loosening credit still further.... Secretary Humphrey agreed with me and promised to put the utmost pressure on Chairman Martin of the Federal Reserve Board in order to get a greater money supply throughout the country" (Eisenhower 1981, 278). When Martin refused to provide accommodating policy, Eisenhower pressured him to resign or comply; Martin ended up malting a "promise to ease credit if the economy slowed" (Meltzer 2009a, 135). The Fed ultimately "could not buck a direct plea from the White House" and accommodated Eisenhower (Kettl 1986, 88).

In November 1955, the Treasury had difficulty issuing securities on the market, so the Federal Open Market Committee (FOMC) supported the debt issue (Clifford 1965, 313; Bach 1971, 95). Looking at this period, Jerome Clifford observes: "Such quick and strong cooperative action showed that there was indeed a 'revolving door' in the 'fence' between the independent agencies, the Treasury and the Federal Reserve. Perhaps it could be said that really the fence was invisible and that the neighbors cultivated a common garden, but each with his own tools" (1965, 321). The stagnating state of the economy in 1956 was a cause of concern for the Eisenhower administration during an election year, so Eisenhower encouraged Arthur Burns, then on the CEA, to push the Fed toward monetary easement (Meltzer 2009a, 135). A Fortune writer summarized the views of a young Alan Greenspan at the time: "The Fed ... has recently been boxed in by a huge and partially monetized federal debt, which tends to produce an addition to the money supply, whose size is unrelated to the needs of private business" (Burck 1959, 201).

The pressure for favorable monetary policy in the 1960s started immediately with the election of John Kennedy (Havrilesky 1995b, 55-58; Meltzer 2009a, 262). Martin caved in to pressure for monetary expansion from Kennedy, the Treasury secretary, and the budget director, reversing his previous policy stance (Kettl 1986, 93, 98-99; Havrilesky 1995b, 56; Meltzer 2009a, 269, 317, 323). Kennedy successfully pressured Martin to cater monetary policy to Operation Twist, a plan by the Kennedy administration to invert the yield curve, despite the Fed's opposition to the policy (Vencill 1992, 203; Havrilesky 1995b, 57). (2) Under Kennedy, Allan Meltzer records, the independence of the Fed was supplanted by the coordination of fiscal and monetary policy (2009a, 283, 287, 316, 417). Meltzer observes that in one particular episode "there is no denying administration involvement in the discount rate increase. Even if [Martin] did not make a formal commitment, the change had been discussed with administration officials as part of a package before it was brought to the bank presidents" (2009a, 418).

When Lyndon Johnson took office in 1963, he vastly expanded spending to undertake his Great Society' programs and the Vietnam War. He immediately started pressing for accommodating monetary policy (Newton 1983, 70; Havrilesky 1995b, 58-59; Hetzel 2008, 69; Meltzer 2009a, 262, 443-45, 456-57). (3) During this time, the Fed was explicitly catering monetary policy to the Treasury's needs (Bach 1971, 124). The FOMC's Records of Policy Actions reveal that targets were always qualified with the phrase "to the extent permitted by Treasury financing" (Timberlake 1993, 338). Although...

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