100 years of the US Federal Reserve

In retrospect not the best of decisions, however thanks to it we have learned a lot about monetary policy over the past 100 years (this is purely academic curiosity talking). Then again, many economists still disagree over what monetary policy can and can not do (and more importantly under which circumstances it can or can not react), which is probably why monetary policy is one of the most misunderstood areas of economics for laymen. Yet another reason why preserving central bank independence (both goal and instrumental) is crucial for financial stability. 

Anyway, the NBER has organized a conference for the occasion, featuring some impressive names in the field of monetary policy, including former governor Paul Volcker, Stanley Fischer, Larry Summers, Martin Feldstein, Jean-Claude Trichet, Frederic Mishkin, Carmen Reinhart, David and Christina Romer, and of course current Fed Chairman Ben Bernanke. Here are some interesting parts from his speech (a fairly well historical overview of 5 important, "Great" episodes of the Fed's history: the founding, the Great Depression, the stagflation of the 70-ies, Paul Volcker's Great Moderation, and finally the recent current Great Recession):

"The Great Depression was the Federal Reserve's most difficult test. Tragically, the Fed failed to meet its mandate to maintain financial stability. In particular, although the Fed provided substantial liquidity to the financial system following the 1929 stock market crash, its response to the subsequent banking panics was limited at best; the widespread bank failures and the collapse in money and credit that ensued were major sources of the economic downturn ... Economists have also identified a number of instances from the late 1920s to the early 1930s when Federal Reserve officials, in the face of the sharp economic contraction and financial upheaval, either tightened monetary policy or chose inaction. ... It may be that the Federal Reserve suffered less from lack of leadership in the 1930s than from the lack of an intellectual framework for understanding what was happening and what needed to be done."

... With respect to goals, the high unemployment of the Depression ... elevated the maintenance of full employment as a goal of macroeconomic policy. The policy framework to support this new approach reflected the development of macroeconomic theories--including the work of Knut Wicksell, Irving Fisher, Ralph Hawtrey, Dennis Robertson, and John Maynard Keynes--that laid the foundations for understanding how monetary policy could affect real activity and employment and help reduce cyclical fluctuations. At the same time, the Federal Reserve became less focused on its original mandate of preserving financial stability, perhaps in part because it felt superseded by the creation during the 1930s of the Federal Deposit Insurance Corporation and the Securities and Exchange Commission, along with other reforms intended to make the financial system more stable."

Stagflation of the 70-ies, caused by the ignorance of conventional economic thought at the time, however fixed by accepting new paradigms from Friedman, implemented by Volcker: 

"...beginning in the mid-1960s, inflation began a long climb upward, partly because policymakers proved to be too optimistic about the economy's ability to sustain rapid growth without inflation "... policymakers chose to emphasize so-called cost-push and structural factors as sources of inflation and saw wage- and price-setting as having become insensitive to economic slack. This perspective, which contrasted sharply with Milton Friedman's famous dictum that "inflation is always and everywhere a monetary phenomenon," led to Fed support for measures such as wage and price controls rather than monetary solutions to address inflation. A further obstacle was the view among many economists that the gains from low inflation did not justify the costs of achieving it.

The consequence of the monetary framework of the 1970s was two bouts of double-digit inflation. Moreover, by the end of the decade, lack of commitment to controlling inflation had clearly resulted in inflation expectations becoming "unanchored," with high estimates of trend inflation embedded in longer-term interest rates.  

As you know, under the leadership of Chairman Paul Volcker, the Federal Reserve in 1979 fundamentally changed its approach to the issue of ensuring price stability. This change involved an important rethinking on the part of policymakers. By the end of the 1970s, Federal Reserve officials increasingly accepted the view that inflation is a monetary phenomenon, at least in the medium and longer term; they became more alert to the risks of excessive optimism about the economy's potential output; and they placed renewed emphasis on the distinction between real--that is, inflation-adjusted--and nominal interest rates. The change in policy framework was initially tied to a change in operating procedures that put greater focus on growth in bank reserves, but the critical change--the willingness to respond more vigorously to inflation--endured even after the Federal Reserve resumed its traditional use of the federal funds rate as the policy instrument. The new regime also reflected an improved understanding of the importance of providing a firm anchor, secured by the credibility of the central bank, for the private sector's inflation expectations. Finally, it entailed a changed view about the dual mandate, in which policymakers regarded achievement of price stability as helping to provide the conditions necessary for sustained maximum employment."

Read the full speech, it's a very good monetary history lesson. I also recommend some of the papers presented at the conference. 

Oh, and celebrate! Who knows what we are to expect in the next 100 years of the Fed. I'm hoping we can learn even more. It's all trial and error in economics anyway.