A History of the Federal Reserve, Volume 2 (101 page)

Adhering to an explicit inflation target can overcome the problem of giving excessive attention to recent events and reports that are frequently revised. Some FOMC members have recognized these problems, but until recently they did not offer an alternative. Flexible inflation targeting that seeks to control inflation and minimize loss of output is an alternative. But it should not be adopted without congressional acceptance of the proposal. Congress could require a target for the unemployment rate as in Humphrey-Hawkins legislation. Congressional authority over money stems from the Constitution. The Federal Reserve is its agent. If principal members of Congress concerned with monetary policy do not accept or acquiesce in the proposal, it is unlikely to succeed or remain.

Inflation targeting introduces rule-like behavior, the type of behavior Otmar Issing suggested in the epigraph to this chapter. It provides a solution that is neither fully discretionary nor a rigid rule. Under the dual mandate, the public knows that the central bank aims to achieve both a low rate of inflation and sustained growth, so it can develop its plans with less fear of unanticipated disturbances. Of course unforeseen events do occur. Financial distress is one of the most important: The Federal Reserve is the lender of last resort. To carry out this function, it departs temporarily from its rule-like stance for monetary policy. Former Chief of Staff Stephen Axilrod concluded after years of experience that the best course for monetary policy is somewhere between discretion and a rule.

Since the 1970s, the Federal Reserve has improved its operation as lender of last resort. It recognized that this function requires response to the financial system, not just banks. But in its more than ninety years, it has never announced a strategy or rule, and it has not been consistent. It helped First Pennsylvania and Franklin National to survive. It allowed Drexel, Burnham to fail, but it helped in the rescue of Long-Term Capital Management. These and many other examples create uncertainty that contributes to the virulence of the market’s reaction to crises and to pressures for assistance and bailouts. Recent credit problems show much evidence of changing actions and inconsistent responses.

Significant changes in policymaking occurred in the 1980s and thereafter. The Federal Reserve now distinguishes real and nominal interest rates and exchange rates. It recognizes that policy should not be made one meeting at a time, although it is not always willing to give longer-term objectives greater weight than short-term, possibly transitory or random, events. It gave up regulation Q interest rate ceilings. In 1994 and 2001, it successfully implemented counter-cyclical policy actions. In 1994 it be
gan to announce the current interest rate target and some clues to what it planned for the next meeting.

The Federal Reserve did not adopt a rule, but it encouraged the belief that it aimed at a 1 to 2 percent inflation rate, presumably in the deflator for personal consumption expenditure net of food and fuel prices.
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Economists then opened discussion of what in addition a central bank should announce. Some proposed announcing a path for expected interest rates or policy actions. Others proposed publication of quarterly forecasts for output and inflation or financial market risk.
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Some smaller central banks publish their interest rate projections. They are price takers in the interest rate market. The Federal Reserve is a price setter; its announcements carry weight in world markets, so it must be cautious about what it announces. A possible rule of thumb is to release information that it believes will not mislead the public and the market. The information should enhance, or at least not diminish, Federal Reserve credibility.

Many central banks make explicit their objective of controlling inflation, and they recognize the central role of inflationary expectations in the inflationary process. This, also, could be a major change for the Federal Reserve.

The Federal Reserve has not tried to agree on a common framework for analyzing the economy and its actions. The best that it can expect to do is agree on a rule such as the Taylor (1993) interest rate rule or the Meltzer (1987) and McCallum (1988) rule for monetary base growth. These rules are compatible with several different models or frameworks. FOMC members with different views can base their decisions on a rule without trying to agree on the model that determines the economy’s path. These rules are relatively simple, an advantage in communicating them.

Fischer (1994) and Blinder (1998) proposed that the political authority should choose the central bank’s objective, leaving the central bank freedom to choose how to achieve the objective. Few countries go as far as the Europeans who set the objective—price stability—in law. The United States law in 1946 called for maximum employment and purchasing power and left to officials to decide on the interpretation. In 1977, Congress amended the Federal Reserve Act to make the objective maximum employment, stable
prices, and moderate long-term interest rates. In practice, the Federal Reserve chooses its objective aware that congressional committees and the public have to be informed. This procedure permits the Federal Reserve, as in 1979–82, to take unpopular action to achieve a popular medium-term goal. Independent choice of objectives can be valuable. Congress can, if it chooses, demand a different objective, as some members started to do in 1982.

16. This measure is subject to larger revisions than the consumer price index. As noted above, for “rule” one should read “rule-like behavior.” Blinder (1998, 37) objected to treating rules based on outcomes as rules because central bankers had to make judgments to adapt to changing circumstances. Announcing the “rule” informs the public about the bank’s medium-term objectives. In November 2007, it brought back overall price inflation in addition to “core” measures.

17. FOMC has announced and published forecasts semiannually for thirty years. In November 2007, it changed to quarterly frequency and extended the range of its forecasts to three years ahead.

One of the lessons of Federal Reserve history is that coordination agreements with other central banks fail and are abandoned. The basic reason is that the primary objective of modern central banks in principal countries is domestic. International coordination introduces a conflicting objective, usually the nominal exchange rate. The gold exchange standard, the Tripartite Agreement, Bretton Woods, and the Louvre agreement all failed. One or more countries was unwilling to put exchange rate stability ahead of domestic employment and price stability.

It is well-known that no country can achieve internal and external stability acting alone. To achieve some of the advantages of international coordination while pursuing domestic goals, the major central banks—the Federal Reserve, the European Central Bank, and the Bank of Japan—can announce a domestic inflation target, preferably a common target. The common target would gradually remove or reduce changes in expected inflation as a source of exchange rate adjustment, leaving real exchange rate adjustment as the principal reason for change. Each country would manage its policy without active coordination (Meltzer, 1987).

This system permits small and medium-sized countries to fix their exchange rate to one or more of the large countries. They benefit by having a fixed exchange rate and importing low, or preferably zero, inflation. The three major countries benefit by facing fixed exchange rates at small and medium-sized countries while permitting real and nominal exchange rate adjustment to changes in productivity, tastes, and demands.

In recent years, some economists have proposed that central banks should respond to asset price changes as well as output and inflation. In many papers, Karl Brunner and I introduce asset prices and expected returns to capital as variables important in the transmission of monetary policy. These models separated markets for money and credit. The underlying structure had three assets: base money, government debt, and real capital. Recent work by Goodfriend and McCallum (2007) brings a modern version of money and credit market interaction.
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18. Earlier Bernanke and Blinder (1988) introduced a “credit channel.” They add bank lending as a distinct asset market and implicitly combine bonds and real capital, so assets consist of money, credit, and a mix of bonds and real capital.

Empirical estimates from these models provide information about the response of reported inflation and output to asset prices. A major problem for central banks and others is to determine whether asset price changes reveal inflationary pressures, productivity changes, or changes in the expected return to capital that raise or reduce the real value of assets. Central banks should not respond to asset price changes. If they can identify the inflationary component, central banks should respond to expected inflation from this source as from any other. That is, they should follow rule-like behavior.

The Federal Reserve should increase its effort to develop a common framework for analyzing the economy and the transmission path by which policy and other changes influence its objectives. Currently, there are three approaches. First is an elaborated version of the IS-LM model supplemented by a Phillips curve and some expectations model. This has been used and modified for decades. It was the source of persistent, large errors in forecasting inflation. Second is the analytic model developed by Woodford (2003), which emphasizes the role of rational expectations as the link between a short-term interest rate and other relative prices. Third is the relative price transmission mechanism (Brunner and Meltzer, 1993 and elsewhere). It highlights the central role of asset prices and the expected return to real capital in the transmission of policy and other impulses. In this model, monetary policy changes the relative price of current and future consumption and the relative price of new and existing capital.

CONCLUSION

This chapter summarizes some of the main lessons learned by the Federal Reserve and other central banks from experience and actions. Central banks are much more professional and, as a consequence, better equipped to avoid major mistakes of the past. Through much of the last half of the twentieth century, central banks struggled to find an alternative to the gold standard rule and the rule for balanced budgets. Economists pointed out that the gold standard was procyclical and that discretionary monetary and fiscal actions could produce well-timed policy changes that would improve welfare. They ignored the discipline that the two rules maintained. The result was a large inflation lasting many years and reaching many countries. One result of the Great Inflation was renewed effort to develop stabilizing rules for the conduct of monetary policy. Following the German Bundesbank’s relatively successful results, the Maastricht Treaty adopted the Bundesbank’s objective—price stability—as the policy objective. Progress can continue. Useful steps include more attention to rule-like
behavior, more attention to medium-term consequences, less attention to noisy quarterly or monthly data, and a common international inflation rule that increases nominal exchange rate stability. Reliance on the Taylor rule as a medium-term guide is a good place to start. In conducting its function as regulator of financial firms and lender of last resort, the Federal Reserve should give more attention to incentives, and less to command and control, and it should announce and follow a rule or strategy for crises. Lawyers and bureaucrats write most regulations. Markets decide how and whether to circumvent them. Regulation will be more effective if it takes account of the incentives it creates and adjusts its rule to give incentives for improved behavior.

Large future budget deficits to pay for promised social security and health care benefits will likely challenge the Federal Reserve in the future. Inflation is one way of reducing the real value of these promises. If Congress is unwilling to reduce promised benefits or raise tax rates, the Federal Reserve will be pressed to expand money growth to finance deficits. Adopting a non-inflationary rule may help to reduce pressures to inflate.

Experience in the twenty years following the Great Inflation suggests the size of the welfare gain from avoiding inflation and disinflation. The economy experienced three of the longest periods of growth with only two relatively mild recessions. Per capita disposable income increased 33 percent, an average of 1.6 percent a year. Real aggregate personal consumption rose from $4.2 trillion to $8.2 trillion, $200 billion per year. Inflation remained low. This is an enviable record that monetary policy should seek to repeat regularly.

To end this history, it is useful to repeat from the start of Volume 1 the advice Henry Thornton ([1802] 1962, 259) gave independent central bankers two hundred years ago. The policy should be

to limit the total amount of paper issued, and to resort for this purpose, whenever the temptation to borrow is strong, to some effectual principle of restriction; in no case, however, materially to diminish the sum in circulation, but to let it vibrate only within certain limits; to allow a slow and cautious extension of it, as the general trade of the kingdom enlarges itself. . . To suffer the solicitations of the merchants, or the wishes of government, to determine the measure of bank issues, is unquestionably to adopt a very false principle of conduct.

EPILOGUE: THE UNITED STATES IN THE GLOBAL FINANCIAL CRISIS OF 2007-9 

Events following the start of the housing, mortgage, and credit market crises in summer 2007 opened a new chapter in Federal Reserve history. Never before had it taken responsibility as lender of last resort to the entire financial system, never before had it expanded its balance sheet by hundreds of billions of dollars or more over a short period, and never before had it willingly purchased so many illiquid assets that it must hope will become liquid assets as the economy improves. Chairman Ben Bernanke seemed willing to sacrifice much of the independence that Paul Volcker restored in the 1980s. He worked closely with the Treasury and yielded to pressures from the chairs of the House and Senate Banking Committees and others in Congress.

Events highlighted several of the flaws in Federal Reserve policy discussed in this volume. Current pressures dominated longer-term objectives. The Board had never developed or enunciated a lender-of-last-resort policy. Markets had to observe its actions and interpret the statements as always in the past. Instead of reducing uncertainty by offering and following an explicit lending policy rule, it continued to prevent some failures while permitting others. It failed to give a believable explanation of its reasons and reasoning.

One of the main failings of monetary policy in 1970s was the neglect of longer-term consequences of near-time actions. Whenever the unemployment rate rose to about 7 percent, the members abandoned any concern about the inflationary consequences of their actions. Preventing inflation
had to wait. When the right time came, it didn’t remain long enough to end inflation. Raising interest rates and slowing money growth raised the unemployment rate, so policy became expansive again. The result: inflation and unemployment both rose.

Marvin Goodfriend, Alan Greenspan, Robert Hetzel, Andrew Levin, John Taylor, and Peter Wallison provided helpful comments. Fallout from the crisis continues as this is written.