Learning about policy from federal reserve history.

AuthorMeltzer, Allan H.

For much of the past 15 years, my assistants and I have been reading minutes and papers in the National Archives, the Board of Governors, and the New York Federal Reserve Bank. I owe a debt of appreciation to the Board's librarians, to the achivists at the New York bank, to my several assistants, mad to many at the Fed who cooperated helpfully to make this project come to completion. (1) The result has now been published in two volumes of more than 2,000 pages. Volume 1 covers the 1913-1951 period and has been in print several years (Meltzer 2003). Volume 2, published in February, is in two parts: part one (Meltzer 2010a) covers the 1951-69 period, and part two (Meltzer 2010b) chronicles the 1970-86 period.

In this article, I discuss some principal findings from volume 2. The starting point is the 1951 Accord with the Treasury that permitted the long-term interest rate to rise above 2.5 percent. The closing point is the end of the Great Inflation in 1986.

Volume 2 has two main themes. One is the Great Inflation. I discuss why it started, why it continued for more than 15 years, why it ended when it did, and why it has not returned, at least not yet. The second theme is the changing meaning of independence.

Much of my book is about policy errors and mistaken ideas. That is what makes the book so long. I let the principals make their arguments repeatedly to make clear that they believed in their reasons for acting as they did. Repetition reinforces my interpretations. Because I will talk about mistakes, let me start by saying a bit about achievements.

The United States is the world's main monetary power. The Federal Reserve presided over file 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 mad 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 United States 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.

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. I limit discussion here to domestic policy and operations.

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 4 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.

Independence

History, at least mine, tells a mixed story. In the postwar years, only part of Paul Volcker's period as chairman, 1979 to 1984, comes close to the textbook vision of independence. President Reagan appointed the majority of the Federal Reserve Board during Volcker's last years as chairman, and James Baker influenced those members. On one occasion, the Board voted 4 to 3 for a discount rate reduction that Paul Volcker opposed. And, as Treasury secretary, Baker chose an exchange rate policy that the Federal Reserve had to accept.

William McChesney Martin, Jr., defined Federal Reserve independence as "independence within the government, not independence of the government." His definition recognizes a political constraint. Martin said many times that Congress approves the budget and decides on the deficit. He thought and said the Federal Reserve had to help finance the deficit. This worked reasonably well during the Eisenhower and Kennedy presidencies when the budget was in surplus or the deficits relatively small. It produced high money growth and rising inflation during the Johnson presidency, when deficits rose. Not deficits but Federal Reserve policy of financing deficits started and sustained the Great Inflation. My history gives many other examples of political influence on the Fed.

When President Nixon appointed Arthur Burns to chair the Federal Reserve, the president left no doubt about his view of Federal Reserve independence. He told Burns and the audience that he expected the Federal Reserve to independently decide to do what he wanted done. President Nixon promised to reduce inflation without a recession. His advisers warned him that this would not happen. President Nixon said that no president is defeated for reelection because of inflation, only because of unemployment.

Burns shared his conviction. In "The Anguish of Central Banking" (1987) he explained that the Federal Reserve should have reduced money growth 'after 1964. They couldn't, he said, because of the political commitment to the welfare state, and the power of labor unions and business monopolies. Burns gave that speech at the 1979 International Monetary Fund meeting in Belgrade. That was the meeting Paul Volcker left early to do what Burns said could not be done.

William Miller followed Burns as chairman. He knew very little about making monetary policy. His main contribution was negotiating an agreement with Congress to end Regulation Q ceilings. The Carter administration wanted a chairman who was more cooperative than Burns. Maintaining independence was not an important concern.

The Federal Reserve has much less independence than the European Central Bank because the government of the European Union has a much smaller role in monetary policy than the U.S. administration and Congress. Congress can change the rules under which the Federal Reserve operates, and it proposes to do so frequently. Federal Reserve officials are very aware of this limit on their actions. Economists cannot understand Federal Reserve policy if they ignore political influences.

Central bank independence became explicit under the gold standard. That standard constrained monetary policy mad inflation expectations. (2) Unrestricted independence 'allowed the Federal Reserve to finance the Great Inflation because Congress at the time gave much greater concern to unemployment than to inflation. I believe Congress should restore independence but restrict Federal Reserve actions to a quasi-rule such as the Taylor Rule. If the FOMC decides to depart from the quasi-rule, it should offer both an explanation and resignations. The administration can accept the explanation or the resignations. That would better align responsibility and authority.

Some Principal Errors

Federal Reserve minutes record major errors. The Federal Reserve has never agreed on a framework for monetary policy. FOMC minutes or transcripts show many divergent views. Although the staff produces forecasts of future outcomes, the FOMC neither accepts nor rejects the staff's work. Most of the policy discussion in 1951-1986 is about near-term actions and in the 1970s and after 1989 whether to change the nominal federal funds rate or reserves by one-eighth or one-quarter of a percentage point. The real rate is not mentioned. Most members did not discuss the medium- or longer-term consequences of their actions. The Voleker disinflation is an exception that succeeded by concentrating on the medium-term objective of lower inflation.

In the February 14, 1972, FOMC Minutes, Sherman Maisel recognized the absence of any statement about medium-term implications:

First, the FOMC did not have a clear enough picture of the relationship between changes in operating variables ... and changes in the intermediate monetary variables. Second, there was insufficient understanding of the relationship between changes in the intermediate variables and changes in the economy.... Third, there tended to be insufficient discussion of developments with respect to the demand for money.... Finally, the time period on which the Committee focused in its policy deliberations was often...

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