Evolution of Monetary Policy and Financial Stability: Lessons from the First 100 Years of the Federal Reserve
The Federal Reserve's journey over a century reflects the evolution of monetary policy and financial stability. From its founding to responses to crises like the Great Depression and Great Recession, the Fed's policies have adapted to changing economic landscapes. Understanding these historical events provides valuable insights into the central bank's role in maintaining economic stability and growth.
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The Fed at 100: Monetary Policy Performance and Lessons from a Century of Central Banking David C. Wheelock Vice President and Deputy Director of Research Federal Reserve Bank of St. Louis December 6, 2013 The views expressed in this presentation are not necessarily official positions of the Federal Reserve Bank of St. Louis or the Federal Reserve System.
End the Fed? The Fed s response to the recent financial crisis was vigorous and controversial; monetary policy remains controversial Need to distinguish crisis response (lender of last resort) from monetary policy response to the recession and beyond The Fed now views financial stability and monetary policy as coequal responsibilities of the central bank (Bernanke, 2013). How has Fed policy been shaped by events in the Fed s first 100 years, especially the Great Depression and the Great Inflation?
In the Beginning, Financial Stability was the Only Goal The Fed s founders sought to prevent banking panics by furnishing an elastic currency. The Fed would rediscount commercial paper (loans) for member banks in exchange for currency (Federal Reserve notes) and reserve deposits. The Fed supplied currency and reserves passively (against acceptable collateral) to satisfy demand. The founders did not conceive of monetary policy as we think of it today. The gold standard and adherence to real bills principles would ensure an optimal money supply (i.e., support economic activity without inflation).
The Great Depression A successful first 15 years, 1914-29 No crises Price stability Federal Reserve credit eliminated the seasonal fluctuations in interest rates The Fed learned to use open-market operations to influence interest rates and achieve macro objectives, i.e., to conduct monetary policy But, then there was the Great Depression Banking panics returned Severe economic collapse with a prolonged recovery
The Great Depression and Great Recession Period Length in Months Real GDP: Percent Decline Peak to Trough Unemployment: Max Value During Recession CPI: Percent Change Peak to Trough 36.2% 27.2% 1929-33 43 25.4% 4.7% 2007-09 18 10.0% 1.6%
Banking Crises Brought Deflation USD Billions Index, 1982-84=100 1929 Crash 50 20 First Banking Panic Second Banking Panic 45 18 UK off gold standard 40 16 Final Banking Panic 35 14 30 12 M2 (Left Axis) CPI (Right Axis) 25 10 1929 1930 1931 1932 1933 Sources: National Bureau of Economic Research, Bureau of Labor Statistics & Haver Analytics Last Observation: December 1933
The Feds Tepid Response to Crises USD Millions 5000 Other Fed Credit 4500 Federal Reserve U.S. Govt. Securities Portfolio Final Banking Panic 4000 Federal Reserve Loans 3500 U.K. Off Gold Standard 3000 Stock Market Crash 2500 First Banking Panic 2000 1500 1000 500 0 1929 1930 1931 1932 1933 1934 Sources: Federal Reserve Board, Banking and Monetary Statistics 1914-1941 Last Observation: December 1934
Where was the Fed? Fed officials misinterpreted financial conditions: They viewed a lack of discount window borrowing and low nominal interest rates as evidence of monetary ease. However, the discount window was closed to nonmember banks, required collateral, and entailed stigma not a good signal of banking conditions Deflation caused the real interest rate to rise, which increased the cost of borrowing and discouraged investment spending. Low nominal rates reflected a collapsing economy, not monetary ease.
Deflation Caused Nominal and Real Interest Rates to Diverge Percent, 3-Month Banker's Acceptance Rate Real i = Nominal i Inflation Rate 16 Nominal 14 Real 12 10 8 6 4 2 0 -2 1929 1930 1931 1932 1933 Last Observation: December 1933
Recovery: No Thanks to the Fed Rapid money supply growth beginning in 1933 (Bank Holiday and deposit insurance ended banking panics; gold inflows increased the money supply; no Fed actions) rising price level falling real interest rate increased spending
The Real Interest Rate and Business Investment Treasury Bill minus Inflation Rate, Percent USD Billions 12 14 10 11 8 8 6 5 4 2 2 -1 Business Investment (Left Axis) Real Interest Rate (Right Axis) 0 -4 1929 1930 1931 1932 1933 1934 1935 1936 1937 1938 1939 1940 1941 Last Observation: 1941
M2 & Nominal GNP, 1929 - 1941 USD Billions USD Billions (SA) 65 120 60 110 55 100 50 90 45 80 40 70 35 60 M2 (Left Axis) 30 50 Nominal GNP (Right Axis) 25 40 1929 1930 1931 1932 1933 1934 1935 1936 1937 1938 1939 1940 1941 Sources: National Bureau of Economic Research & Haver Analytics Last Observation: December Q4-1941
Some Lessons from the Great Depression Money matters The central bank should respond aggressively to crises (lender of last resort); The central bank should strongly resist deflation Financial crises can have serious macroeconomic impacts Recessions associated with financial crises tend to be more severe than others and recoveries are sluggish More effort required to produce a vigorous recovery Regime changes may be needed to restore confidence in banks and sustain recovery
More Mistakes: The Great Inflation Percent Percent 10 12 Inflation (Left Axis) 9 M2 Growth (Right Axis) 10 8 7 8 6 5 6 4 4 3 2 2 1 0 0 1951 1955 1959 1963 1967 1971 1975 1979 1983 1987 1991 1995 Source: Federal Reserve Board, Bureau of Labor Statistics & Haver Analytics Last Observation: 1995
Where was the Fed? Misled by nominal interest rates again the real rate was low, sometimes negative, encouraging borrowing and spending. Monetary policy was not tight. Misled by the Phillips Curve policymakers believed that unemployment could be reduced permanently by allowing a higher inflation rate. Incorrect ideas about the causes of inflation (budget deficits, oil shocks, labor unions, etc.)
Nominal & Real Interest Rates Percent 20 15 10 5 0 -5 Real Interest Rate Nominal Interest Rate -10 1965 1967 1969 1971 1973 1975 1977 1979 1981 1983 1985 Source: Federal Reserve Board, Bureau of Labor Statistics & Haver Analytics Last Observation: December 1985
Phillips Curve 1959-68 & 1969-85 CPI Inflation Rate CPI Inflation Rate Phillips Curve 1959-68 Phillips Curve 1969-85 6 14 1980 5 12 1979 1968 1974 1981 4 10 1975 1966 3 8 1967 1978 2 1977 1965 1960 1973 1982 1976 1963 6 1969 1961 1970 1 1964 1962 1984 1971 1959 4 0 1985 1983 1972 -1 2 2 3 4 5 6 Unemployment Rate 7 8 3 4 5 6 7 8 9 10 11 Unemployment Rate Source: Federal Reserve Board, Bureau of Labor Statistics & Haver Analytics Last Observation: 1985
Lessons from the Great Inflation Inflation is a monetary phenomenon (just as deflation was a monetary phenomenon in the 1930s) The stance of monetary policy is reflected in the real interest rate, not the nominal rate (again, like the 1930s) No long-run tradeoff between inflation and unemployment Monetary policy cannot permanently lower the unemployment rate (long-run monetary neutrality)
Lessons Learned? Policy in 2007-09 Lender of Last Resort (financial stability) actions: Loan facilities for banks and other financial firms (TAF, PDCF, etc.) Special facilities for specific firms (Bear Stearns, AIG) Stress Tests for the largest firms (made permanent) Monetary Policy actions: Cut interest rates (ultimately to zero) Forward guidance Treasury and MBS purchases ( QE ) No deflation; no depression
Looking Forward The Fed drew lessons from prior crises, especially the Great Depression, in 2007-09. With inflation low, the Fed has also apparently avoided the mistakes of the Great Inflation, but much of the history of the current episode remains to be written.
