Federal Reserve Monetary Policy If taxation without representation could rally the colonists against the British Crown in 1776, tight money and ruinous interest rates might be cause for populist revolt in our own day. Federal Reserve monetary policy also has severe social burdens, measured by huge changes in aggregate output, income, and employment. The imperious Fed, much like the English Crown two centuries ago, formulates and carries out its policy directives without democratic input, accountability, or redress. Not only has the Fed’s monetary restraint at times deliberately pushed the economy into deep recession, with the attendant loss of millions of jobs, but also its impact on the structure of interest rates and dollar exchange rates powerfully alters the U.S. distribution of national income and wealth.
Federal Reserve shifts in policy have generated economic consequences that at least equal in size and scope the impact of major tax legislation that Congress and the White House must belabor in public debate for months. Popularized studies of Federal Reserve performance in recent decades convey the image of the Fed seated in its Greek temple on Constitution Avenue, with Chairmen Volcker and Greenspan elevated to the realm of the gods. From centers of economic power around the nation – Wall Street, Capitol Hill, the White House, and corporate boardrooms – the classical Greek chorus intones its defense of Federal Reserve independence. On the surface, central bank independence seems an eminently reasonable, appealingly simple solution for an agonizingly complex and muddled process of making economic policy in this postindustrial, electronically linked, and computerized global economy. The independent central bank is an institutional concept that complements well the counterrevolution now underway in U.S.
budget policy. Washington’s fiscal policy is locked into a deficit-cutting mode for the near future, while Congress is determined to retreat from all discretionary spending, regulatory intervention, or measures to improve equity in the distribution of national income and wealth. With the federal fiscal policy on automatic pilot, the Fed’s monetary policy could be removed entirely from the inefficiencies and confusion of the democratic process. But this deceptively simple conception poses profound questions for the process of democratic representative government in the United States as it pertains to managing the nation’s economy. Federal Reserve independence has a direct impact on the daily lives of most Americans in their pursuit of happiness, of which their economic welfare is a major element.
Since World War II, the Federal Reserve, together with policy makers on Capitol Hill and the White House, gradually worked out strategies for achieving a balance between tolerable rates of unemployment and inflation. The government was determined to prevent the recurrence of the kind of massive unemployment suffered in the Depression of the 1930s. In 1944, President Franklin Roosevelt set forth the basis for his postwar domestic program in an Economic Bill of Rights. His number one priority was the right to a useful and remunerative job. Congress soon passed the historic Employment Act of 1946 with strong Democratic and Republican support.
It gave the federal government explicit responsibility to promote maximum employment, production, and purchasing power. (This was subsequently amended and strengthened in the Full Employment and Balanced Growth Act of 1978.) In the 1950s and 1960s, both Republican and Democratic administrations pursued the generally accepted goals of full employment, sustainable growth, and minimal inflation. Economic managers shifted weight among the several objectives as the economy moved up and down over the business cycle. During those decades, American economists in the mainstream shared a broad consensus that backed counter cyclical policy aimed at a mix of full employment and reasonable price stability. We now look back on those decades as a period of “golden growth in U.S.
economic history. By the mid-1970s, however, the oil price shocks and the emergence of stagflation shattered the consensus among economists. Arthur F. Burns, chairman of the Federal Reserve Board, described the new world after the first oil price shock had driven the economy into a deep recession in testimony before Congress (October 11, 1974). According to Bums, one of the nation’s most distinguished researchers of the business cycle, the recession was extremely unusual, because it was accompanied by galloping inflation and booming capital investment: said Burns, I have been a student of the business cycle for a long time, and I know of no precedent for it in history.
Thus, by the mid-1970s, soaring oil prices fueled a rising consumer price index (CPI) at double-digit rates in 1974 and again in 1979-80. (Once those oil price crises had passed, however, CPI inflation settled down to relatively modest rates during the past twelve years.(1)) Meanwhile, the unemployment rate had also shifted erratically higher in the 1970s. Unemployment became a persistent problem, alleviated with only a few years of improvement until very recently. In the period of golden growth from 1950 to 1974, the unemployment rate rose above 6 percent in only two recession years (1958 and 1961). In the years of oil price crises and economic and financial turbulence, from 1975 to 1993, the unemployment rate fell below 6 percent in only four years (1979 and 1988-1990).(2) The oil price shocks and the persistence of intolerable rates of both unemployment and inflation -labeled stagflation – tore apart whatever consensus might have existed among economists.
As a result, the broad agreement on economic theory dissolved, as did the basis for economic policy at the national level. The U.S. economic malaise created conflict among those economists and policy makers in the Federal Reserve System who designed and carried out monetary policy, as well as among those at the Treasury, the White House, and in Congress who created tax laws and carried out fiscal policy. The intractable economic crisis led to the election of Ronald Reagan in 1980. His administration adopted a radical supply-side economic strategy that linked a high-deficit fiscal policy to a tight monetarist policy at the Federal Reserve. This historic reversal of policy amounted to a counterrevolution against the New Economics revolution that Kennedy’s economists had launched in the 1960s (on the counter-revolution, see the outline of supply-side economics documented in the Economic Report of the President, 1982; the New Economics revolution is outlined clearly in the Economic Report of the President, 1962). The Kennedy policy mix, in sharp contrast to Reaganomics, had built upon a tightly controlled budget policy with low real interest rates.
The supply-side Reagan counterrevolution had several profound consequences: first, the Economic Recovery Tax Act, passed in August 1981, opened up a structural deficit in the federal budget that was a major cause for the U.S. national debt to rise from $909 billion at the end of 1980 to $2,600 billion when Reagan left office at the end of 1988, and to $4,000 billion when Bill Clinton was elected president at the end of 1992.(3) The on-budget deficit had reached $340 billion in the last year of Republican rule (5.7 percent of GDP). The uncontrolled explosion of the federal budget deficit left the Clinton administration no real choice but to attack the fiscal problem aggressively. Because of Clinton’s budget package passed in 1993, the steep decline of interest rates, and the revival of growth, the deficit has declined faster than expected to some 3.8 percent of GDP in 1994, and to about 2.5 percent estimated for 1995. The second major result of the twelve Reagan-Bush years is that fiscal policy is now locked into a stabilization mode, and therefore paralyzed as a tool for achieving full-employment growth under the mandate of the Employment Act of 1946. Indeed, a steadily declining budget deficit so far in the Clinton administration has dragged down real growth of GDP and slowed the creation of jobs.
Therefore, monetary policy has become the only instrument of macroeconomic policy to cope with short-run cyclical problems and long-run growth. This shift to a tighter fiscal policy has spread abroad to other major countries and has now become an international pattern. From Sweden to Great Britain, Germany, and Italy, politicians have tightened central government budgets to cut down deficits and to reduce intervention of government in the private sector (Steinmo, 1994). In many countries, we can observe the push to privatize nationalized industries, reduce government regulation and free up markets. All across the board, governments are retreating, both as a stimulus to aggregate demand and as an instrument to regulate markets, influence the allocation of resources, and redistribute national income more equitably.
This transformation of policy was occurring at a time when OECD countries had 35 million unemployed and 15 million more underemployed. The remarkable retreat from active fiscal policy, and the role of government as a regulator of economic power and an instrument of economic justice, is another result of the extraordinary philosophical counterrevolution carried out during the Reagan experiment. Government in all its activities from federal to state and municipal levels – even including public education in local communities – was believed to be part of the problem, not the solution of the chronic U.S. economic malaise. The historic retrenchment of the public sector at federal, state, and local levels gained momentum when the Republican landslide in the 1994 mid-term elections wrested control of both the U.S. House and Senate from the Democrats.
The new majority, led by Newt Gingrich, attacked the very foundations of FDR’s New Deal welfare state, and the Federal Reserve emerged clearly as the only institutional instrument to carry out macroeconomic policy. The supremacy of the Fed: Apart from the upheaval in Congress, the year 1994 also signaled the beginning of another cycle of Federal Reserve monetary restraint. On February 4, 1994, Chairman Alan Greenspan announced a quarter-point hike in the Federal funds rate, the first such rise since 1989. Following that decision, interest rates bottomed out and climbed higher, following seven consecutive increases in the Fed funds rate from 3 percent to 6.0 percent(4); the Federal Reserve discount rate was raised from 3 to 5.25 percent. By early November 1994, thirty-year bond yields had pushed through the 8 percent level, rising from their cyclical low of 5.78 percent in the Fall of 1993; as the national economy slowed markedly in response, thirty-year yields have dropped back toward 6.5 percent by early Summer 1995.
As Greenspan had explained, the 1994 restraint was a preemptive strike against the emergence of future inflation. This argument seemed unconvincing, since the economy was improving only moderately well at that time. Even though real growth was picking up, unemployment was falling, and the federal deficit was declining, accelerating inflation was, however, nowhere a visible problem. These deliberate steps to raise the entire spectrum of money and long-term capital rates, despite the fact that inflation had remained at a fairly stable and moderate rate of 3 percent, had generated widespread criticism from Wall Street analysts and bond traders, leaders of U.S. manufacturing and labor, members of Congress from both parties, and academic economists (see the Challenge Symposium, January-February 1995). The Fed’s actions in 1994 and the chairman’s explanations of the FOMC’s motivations are causing analysts to reexamine the Fed’s policy strategies over the past fifteen years. In retrospect, the Federal Reserve’s performance in the turbulent economic times since the early 1970s raises many questions in a number of major policy areas.
The three major functions of the Federal Reserve should be thoroughly examined within the debate over central bank independence: 1. The conduct of monetary and credit policy: This should include an examination of the Fed’s selection of the ultimate goals of policy – price stability versus full employment growth. The Federal Reserve clearly operates under the goals set down in the Federal Reserve Act (including, of course, all the contemporary amendments): the Federal Reserve System and the Federal Open Market Committee should seek to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates (Board of Governors of the Federal Reserve System, 1994, p. 17). The Fed’s ultimate goals are also related to the objectives laid down by Congress in the Employment Act of 1946 (maximum employment, production, and purchasing power).
The Board of Governors, however, seems to set a narrower policy target (zero-rate inflation, for example) that appears at times to conflict with the policy program of Congress and/or the administration. Beyond these ultimate objectives defining the performance of the nation’s economy as set by the body politic, the Federal Reserve has considerable flexibility in setting intermediate target variables and day-to-day operating targets. At various times the Fed has experimented with a variety of money and credit aggregates as guides to achieve the ultimate performance goals. But even in formulating and carrying out policy concerning intermediate targets, the Fed is subject to congressional requirements under the Humphrey-Hawkins Act (1978), amending the Employment Act of 1946. Accordingly, the Fed must announce its targets for growth of money and credit in February of each year and review progress toward the intermediate goals and the economy’s response at midyear.
Meanwhile, the system operates on a daily basis directly on money rates (Federal funds, for example) to achieve the desired level of member bank reserves (excess and borrowed reserves) through day-to-day open-market purchases and sales of government securities, and by lending to the banks through the Fed discount window. Apart from the conduct of monetary policy, two other distinct functions should be examined carefully in any discussion of central bank independence: The regulatory and supervisory role of the Federal Reserve over the banks, other financial institutions and the foreign exchange, money, and credit markets. The lender-of-last-resort function to prevent massive bank failures and breakdowns in the money, credit, and foreign-exchange markets. Functions 2 and 3 are clearly related. Particularly since the oil price crises of the 1970s, inflation has been at the nexus of debate on the Fed and monetary policy.
In the popular mind, inflation has become the subversive force in the capitalist, free-market economy. Even knowledgeable observers in government, experts in the private sector, and certainly Fed officials seem willing to acquiesce to any decision that is made in the name of fighting inflation. To win that battle, a veil of secrecy clouds the Fed’s deliberations and activities. The central bank orchestrates public relations campaigns to present as persuasive a case to the media as possible for raising interest rates and tightening liquidity. Fed chairmen Arthur F.
Burns, Paul Volcker, and Alan Greenspan are famous for their testimonies that disclosed really nothing in substance to the Congress, while Board members have often leaked selected information or even disinformation to the press and sympathetic congressmen.(5) Even the public debates of monetary policy have not been characterized by intellectual honesty and analytical consistency. Some years before his appointment as vice chairman of the Federal Reserve Board, the highly respected academic economist Alan Blinder, in comments on the Fed’s goals in the early 1980s, found the FOMC to place far more weight on low inflation, and far less weight on high employment, than the goals of the body politic . . . the Fed sets up smoke screens – just as its professed conversion to monetarism in 1979 was a smoke screen for pushing interest rates up.
Blinder was pointing to the Fed’s deliberate deceptions in public statements – fondness for baloney, as he called it, that were a cover-up for surreptitiously promoting unemployment (Blinder, 1994). All in the name of fighting inflation! More recently, former Chairman Henry B. Gonzalez of the U.S. House Committee on Banking, Finance and Urban Affairs released a study detailing the Fed’s concerted efforts to conceal from the public and Congress secret transcripts of its FOMC meetings. For seventeen years the Board concealed these secret transcripts, and in late 1993 deliberately planned to deceive and mislead the Congress in testimony before the House Banking Committee (U.S. House of Representatives, 1994). These troubling relations with Congress and the larger public reflect in large part the divergent slants on central bank independence as viewed from Capitol Hill and the Board of Governors.
While these problems should be rather easily corrected, the Fed faces a far more intransigent problem. There is no adequate theory of inflation to guide the FOMC in designing and carrying out an effective anti-inflationary policy. Monetary policy is still approached from the theoretical perspective of the quantity theory of money, a nineteenth-century conception inappropriate as we enter an entirely different twenty-first-century system of institutions, using very different means of payment and financial instruments. Contemporary policy requires new definitions of the most basic concepts – money and credit – not just in a national framework, but in a global system of fully integrated national components. Apart from monetary theory, the theory of the economic system underlying Fed strategy is essentially a nineteenth-century conception that is closer to myth than to reality.
Economic policy based on such a conception disregards the huge concentrations of economic and financial power that characterize the private sector today. Without recognizing the reality of huge power blocs in the money and real economies, central bankers are unlikely to gain control of financial speculation in domestic markets or to curb massive international capital flows that have already effectively defeated concerted central bank intervention to stabilize exchange rates. The emergence of stagflation in the 1970s splintered the economics profession regarding the theory of inflation and the means to combat it. The rise in the price level was not simply the result of excessive growth in the monetary aggregates, and therefore restraining monetary growth was not a satisfactory remedy. Central bankers like Arthur F. Burns, and Henry Wallich, and other researchers including Arthur Okun, Abba Lerner, David Colander, and Sidney Weintraub searched deeper into the economy’s institutional workings for more effective anti-inflationary mechanisms (see Pechman, 1993, esp.
pp. 3-141). Their anti-inflation solutions involved variations of an incomes policy to supplement monetary and fiscal policies. CEA Chair Schultze described the complex process of inflation in 1978 (Schultze, 1978, p. 150). Even when excess demand was not a problem (as in 1977-78), he observed, inflation can persist at unacceptable rates (i.e., the underlying rate of 6 to 6 1/2 percent in those days).
Expectations, cost – push, food price spikes, OPEC oil price hikes, and dollar depreciation were identified as inflationary causes that fed into wages, prices, rent, and lease contracts at every stage of production. Even before Schultze, cost-push inflation theories had been developed by Okun, Weintraub, and others. Conflict theories of inflation as a process involving the straggle over income shares in a world of structural change had been developed in the early 1950s by A.J. Brown and Joan Robinson. There were theories based on rational expectations (Guttmann, 1994). Some conservative Republican economists were acutely concerned about attacking the new inflation of the 1970s. Arthur F.
Burns, after completing his tenure as Federal Reserve Board Chairman (February 1970 to March 1978), advised in his 1979 Per Jacobsson Lecture that central banks will be able to cope only marginally with the inflation of our times (p. 22). But years earlier, at the beginning of his chairmanship, Burns had already outlined a broad anti-inflationary program in his well-known speech at Pepperdine College (December 7, 1970) for a society that properly values full employment, monetary and fiscal tools are inadequate for dealing with sources of price inflation .. from excessive wage increases. Burns came to the conclusion, that it is desirable to supplement our monetary and fiscal policies with an incomes policy, and even advocated a high-level price and wage review board (Burns, 1978, pp.
113-114). Mandatory wage-price controls were part of President Nixon’s New Economic Policy (August 15, 1971). In 1974, when inflation accelerated after the first oil price shock, Burns urged President Ford to adopt some form of wage-price controls. In that instance, the CEA chairman, Alan Greenspan, persuaded the president that wage-price controls were out of the question. Though Burns had unquestioned credibility as a consistent conservative, he frequently and wisely approached anti-inflationary policy in a pragmatic way, supporting bipartisan efforts to hold down the costs of high unemployment, when inflation was attacked with monetary and fiscal restraint. Thus, it is ironic that by the end of the 1970s, when the oil price shocks had demonstrated the complex causes pushing the CPI higher, virtually all conservative …