When the Federal Reserve was created in 1913, Congress did not give it a monetary policy goal as we understand that term today. The Fed’s monetary policy role evolved gradually, and congressional mandates – such as achieving full employment and price stability – came later. Now the question is back at the forefront: What should the Fed be doing?
The Fed Began as a Depository of Bank Reserves. Congress created the Fed in response to financial panics culminating in the Panic of 1907. Those panics spread in part because banks kept their cash reserves with each other rather than in a central location. Withdrawals from Bank A triggered withdrawals from Bank B, then from Bank C, and so on. Withdrawals anywhere would spread through the banking system causing a general contraction of reserves and credit.
Bank reserves were double-counted in that one bank’s reserves (assets) were another bank’s deposits (liabilities). The reserve base shrank when it was needed the most. A scramble for reserves caused credit contraction and a shrinkage of bank notes (paper money) outstanding. More demand for bank notes dried up the supply. The supply was called inelastic.
The Fed was to fix this problem by centralizing bank reserves – hence the name, Federal Reserve System. The Fed was to bring flexibility to the banks’ reserve base and “elasticity” to the currency supply. Simply centralizing the reserves fixed much of the problem; a reserve lending facility did the rest.
The Fed Lends Reserves to Banks. The Fed could lend to the banks by discounting their high-quality bank loans. The Fed’s discount window (lending facilities) and its discount rate offered greater flexibility, and hence stability, to the banking system. At first, the discount rate was the Fed’s only policy tool. Raising it would discourage bank borrowing from the Fed; reducing it would encourage borrowing.
The difference between borrowing from the Fed and borrowing in the interbank Federal Funds market (where banks borrow other banks’ excess reserves) is that borrowing from the Fed creates new reserves for the whole banking system, whereas borrowing in the Fed funds market only reallocates a fixed amount of reserves.
The Fed Buys and Sells Treasury Securities in the Open Market. As Fed lending declined during the 1921 recession, it bought some Treasury securities for income. The broader implications of such open market purchases (and sales) for the banking system was readily apparent. Open market purchases created bank reserves and enabled more credit extension while sales did the opposite. Open market operations became the principal tool of monetary policy.
Legislation authorizing the Fed to change bank reserve requirements, the third tool of monetary policy, came in the mid-1930s, when Congress also formalized the role of the Federal Open Market Committee (FOMC) in open market operations.
The Fed Gets Full-Employment and Zero-Inflation Mandates. The Depression’s hardships along with a new (Keynesian) way of thinking increased pressure on the government to become more activist in countering unemployment and inflation. The Full Employment Act of 1946 formally mandated that the Fed pursue full employment and price stability, although specific targets were lacking. The Act also created a Council of Economic Advisers to monitor the economy for the president.
The Humphrey-Hawkins Act of 1978 mandated unemployment under 4 percent within 10 years and an inflation rate of zero. It also mentioned balance in international payments as another goal. The Fed was directed to achieve these goals through its influence over the money supply, although most economists regarded the goals as mutually exclusive.
The FOMC formally adopted a monetarist approach to policy in October 1979. It set annual target ranges for money growth each year. If money growth was slightly higher or lower than the range at year-end, they set the base of the new target at the actual level of the money supply rather than at the midpoint of the previous year’s target. Some wits called this “base drift” and accused the FOMC of shooting first then drawing the target around the bullet hole.
Financial innovation gradually eroded the tightness of the relationship between money supply growth and economic activity, making a strict monetarist approach to policy less practical. Limiting money growth allowed market interest rates to reach levels much higher than anticipated in 1980-82, but Fed Chairman Paul Volcker showed great courage in “staying the course” until the high rates broke the back of inflation, albeit at the cost of a severe recession.
During this period, from October 1979 to August 1982, inflation-fighting took top priority while the public wanted interest-rate relief. I recall making many speeches touting the “old time religion,” according to which you can’t reduce high interest rates by easing monetary policy since the inflation premium would rise. Inflation expectations had to be broken.
As inflation declined in the 1980s and into the 1990s, output and employment growth continued and the combination of falling inflation and a booming economy became particularly striking in the late 1990s. This happy combination enabled the Fed to finesse the troublesome issue of a conflicting “dual” mandate. It cited research suggesting that price stability is the best environment for rapid growth. The incompatibility problem – although becoming less important at the time – was better understood because of the weakening support in the academic community for the Phillips Curve, which had posited an inverse causal relationship between unemployment and inflation. Exchange rate flexibility effectively removed the external sector as a further conflict with domestic objectives.
Conclusion. Over the years, I believe the majority of Open Market Committee members favored a single mandate of price stability – not all, but probably a majority. Making a single mandate formal, however, didn’t seem worth the danger that bringing the topic up might open Pandora’s box.
I’m surprised, therefore, that proposals for a single inflation mandate would come up now, during this period of low inflation and high unemployment. After all, the Fed’s extraordinary efforts to fight the recent recession have not, in fact, increased inflation – not yet anyway. But I guess I should leave the politics to the politicians.
Robert McTeer is a distinguished fellow with the National Center for Policy Analysis.