Fed Policy - Historical Perspective I: Early Years

1. Fed Policy -Historical Perspective I: Early Years Discount Policy and the Real Bills Doctrine The Fed would buy commercial bank loans at a discount Rediscounting of eligible paper Loans made for “productive” purposes As such, providing reserves to the banking system was not considered inflationary. WWI – inflation hit 14%. Fed increased discount rate to discourage “rediscounting” Caused sharp recession in 1920-21, but reduced inflation to zero and paved the way for the “Roaring Twenties”

2. 1920s - Discovery of Open Market Operations • Early 1920’s • Volume of discount loans shrank dramatically • Fed lost a source of income and started to purchase income-earning assets. • Realized that by doing so could influence the level of reserves in the banking system

3. 1929 – 1933: The Great Depression • Fed failed to act as lender of last resort • Viewed bank failures the consequence of bad management • Did not fully understand the impact on money supply and economic activity • Infighting – Benjamin Strong President of NY Fed • We discussed how the Fed did not understand the money multiplier and failed to increase MB enough.

4. Banking Act of 1935 • 1913 Act failed to spell-out how powers were to be distributed within the Federal Reserve System • Sec. of Treasury and Comptroller of Currency were on the Fed Board. • Banking Act of 1935, amounted to a new “Federal Reserve Act” - Established 14 year terms for Governors. Also created chair and vice chair with 4 year renewable terms. - Required presidential appointment - Fed set reserve requirement within range. - Shielded from Treasury. - Established the FOMC

5. 1936-1937: Reserve Requirement as a Policy Tool • Failed again! • Raised the reserve requirement 3 times in 1936-37.

6. War Finance and the Pegging of Interest Rates • 1942 – 1951 • Fed agreed to peg interest rate at 3/8% on T-bills and 2.5% on the long-term bond • Led to rapid growth in MB and the money supply – why? • March 1951 Fed-Treasury Accord

7. Historical Perspective II William McChesney Martin - 1950s and 60s Fed targets interest rates. Not as a policy instrument – as a goal. Resulted in pro-cyclical monetary policy As Y↑=> i↑=> Fed buys bonds =>MB↑=>M↑ =>i↓ => Y↑ Also, over timeas M↑=> π↑=>i↑=>MB↑=M↑

8. Historical Perspective II - 1950’s and 1960’s • State of macroeconomics • Phillips curve • Use of monetary(and fiscal) policy to “fine tune” the economy. • Resulted in easy monetary policy

9. 2. . . . but in the long run, expected inflation rises, and the short-run Phillips curve shifts to the right. C B Short-run Phillips curve with high expected inflation A Short-run Phillips curve 1. Expansionary policy moves with low expected the economy up along the inflation short-run Phillips curve . . . Phillips Curve: How Expected Inflation Shifts the Short-Run Phillips Curve Inflation Long-run Rate Phillips curve Unemployment 0 Natural rate of Rate unemployment

10. Arthur Burns -1970s • Martin’s Fed faced a lot of criticism for the market interest rate target. • Arthur Burns - stated Fed would target monetary aggregates. • Actually targeted interest rates as well as money growth giving precedence to interest rates. • Set ranges for both money growth and the federal funds rate. • Fed very reluctant to give up control in interest rates • Turned out to be procylical as noted in previous slide.

11. 1979 - 1987 • Paul Volcker • Volcker wanted interest rates to rise – but not a stated policy • Claimed monetary aggregate (non-borrowed reserves)

12. 1987 - Greenspan • Fed Funds becomes Policy Instrument • Target is Announced

13. Historical Perspective III Preemptive strikes against inflation Preemptive strikes against economic downturns and financial disruptions LTCM ENRON Subprime meltdown Taylor Rule framework

14. Should Monetary policy be conducted by Rule or Discretion? • Policy conducted by rule: Policymakers announce in advance how policy will respond in various situations, and commit themselves to following through • Policy conducted by discretion: As events occur and circumstances change, policymakers use their judgment and apply whatever policies seem appropriate at the time.

15. Arguments for Rules • Distrust of policymakers • The time inconsistency of discretionary policy • Definition: A scenario in which policymakers have an incentive to renege on a previously announced policy once others have acted on that announcement • Destroys policymakers’ credibility, thereby reducing effectiveness of their policies. • Open and transparent • Accountability