Discover millions of ebooks, audiobooks, and so much more with a free trial

Only $11.99/month after trial. Cancel anytime.

A History of the Federal Reserve, Volume 2, Book 1, 1951-1969
A History of the Federal Reserve, Volume 2, Book 1, 1951-1969
A History of the Federal Reserve, Volume 2, Book 1, 1951-1969
Ebook1,189 pages21 hours

A History of the Federal Reserve, Volume 2, Book 1, 1951-1969

Rating: 5 out of 5 stars

5/5

()

Read preview

About this ebook

Allan H. Meltzer’s critically acclaimed history of the Federal Reserve is the most ambitious, most intensive, and most revealing investigation of the subject ever conducted. Its first volume, published to widespread critical acclaim in 2003, spanned the period from the institution’s founding in 1913 to the restoration of its independence in 1951. This two-part second volume of the history chronicles the evolution and development of this institution from the Treasury–Federal Reserve accord in 1951 to the mid-1980s, when the great inflation ended. It reveals the inner workings of the Fed during a period of rapid and extensive change. An epilogue discusses the role of the Fed in resolving our current economic crisis and the needed reforms of the financial system.

In rich detail, drawing on the Federal Reserve’s own documents, Meltzer traces the relation between its decisions and economic and monetary theory, its experience as an institution independent of politics, and its role in tempering inflation. He explains, for example, how the Federal Reserve’s independence was often compromised by the active policy-making roles of Congress, the Treasury Department, different presidents, and even White House staff, who often pressured the bank to take a short-term view of its responsibilities. With an eye on the present, Meltzer also offers solutions for improving the Federal Reserve, arguing that as a regulator of financial firms and lender of last resort, it should focus more attention on incentives for reform, medium-term consequences, and rule-like behavior for mitigating financial crises. Less attention should be paid, he contends, to command and control of the markets and the noise of quarterly data.

At a time when the United States finds itself in an unprecedented financial crisis, Meltzer’s fascinating history will be the source of record for scholars and policy makers navigating an uncertain economic future.

LanguageEnglish
Release dateFeb 15, 2010
ISBN9780226519852
A History of the Federal Reserve, Volume 2, Book 1, 1951-1969

Related to A History of the Federal Reserve, Volume 2, Book 1, 1951-1969

Related ebooks

Economics For You

View More

Related articles

Reviews for A History of the Federal Reserve, Volume 2, Book 1, 1951-1969

Rating: 5 out of 5 stars
5/5

2 ratings0 reviews

What did you think?

Tap to rate

Review must be at least 10 words

    Book preview

    A History of the Federal Reserve, Volume 2, Book 1, 1951-1969 - Allan H. Meltzer

    The University of Chicago Press, Chicago 60637

    The University of Chicago Press, Ltd., London

    © 2009 by The University of Chicago

    All rights reserved. Published 2009.

    Paperback edition 2014

    Printed in the United States of America

    21 20 19 18 17 16 15 14      2 3 4 5 6

    ISBN-13: 978-0-226-52001-8 (cloth)

    ISBN-13: 978-0-226-52002-5 (paper)

    ISBN-13: 978-0-226-51985-2 (e-book)

    DOI: 10.7208/chicago/9780226519852.001.0001

    Library of Congress Cataloging-in-Publication Data

    Meltzer, Allan H.

    A history of the Federal Reserve / Allan H. Meltzer

    p.   cm.

    Includes bibliographical references and index.

    Contents: v. 1. 1913–1951—

    ISBN 0-226-51999-6 (v. 1 : alk. paper)

    1. Federal Reserve banks.  2. Board of Governors of the Federal Reserve System (U.S.)  I. Title.

    HG2563.M383 2003

    332.1′1′0973—dc21

    2002072007

    This paper meets the requirements of ANSI/NISO Z39.48-1992 (Permanence of Paper).

    ALLAN H. MELTZER

    A HISTORY OF THE

    Federal Reserve

    VOLUME II, BOOK ONE, 1951–1969

    THE UNIVERSITY OF CHICAGO PRESS

    CHICAGO AND LONDON

    To Christopher C. DeMuth, Marilyn Meltzer, and Anna J. Schwartz

    For their support and encouragement over the many years this history was in process.

    CONTENTS

    Preface

    1. Introduction

    2. A New Beginning, 1951–60

    3. The Early Keynesian Era: A Low-Inflation Interlude, 1961–65

    4. The Great Inflation: Phase I

    Notes

    The reference list and the index appear in volume II, book two.

    PREFACE

    The second, and last, volume of this history covers the years 1951 to 1986 in two parts. These include the time of the Federal Reserve’s second major mistake, the Great Inflation, and the subsequent disinflation. The volume summarizes the record of monetary policy during the inflation and disinflation.

    Early in the Fed’s history, and even in its prehistory, few doubted the importance of separating the power to spend from the power to finance spending by expanding money. The gold standard rule and the balanced budget rule enforced the separation of government spending and monetary policy. By 1951, both rules had lost adherents, especially among academics and increasingly among policymakers and many congressmen.

    The men who led the Federal Reserve during these years made many speeches about the evil of inflation. They made mistakes and gave in to political and market pressures for expansion. Many of their mistakes represented dominant academic thinking at the time. A minority view that opposed the policies was heard from some outsiders and some reserve bank presidents at meetings of the Federal Reserve, but most often it was dismissed or disregarded. The role of the reserve bank presidents fully justifies their continued presence on the open market committee. They often bring new or different perspectives that are not entirely welcome but valuable nonetheless.

    The volume starts with the first major change in Federal Reserve policy following agreement with the Treasury to permit a more independent monetary policy. The volume ends following the second major change to a policy of disinflation. It would be comforting to see these changes as evidence that truth will out. It must be added that both changes followed a shift in political support that facilitated the change. The change to an independent policy did not survive the 2007–9 crisis.

    The Federal Reserve is said to be an independent central bank. The meaning of independence changed several times. In the years after World War II, Congress and several administrations recognized the political implications of unemployment and later of inflation. As a result, the Federal Reserve often found it difficult to follow an independent course. Mistaken beliefs and lack of courage sustained inflationary actions.

    A subject that I do not raise in the text deserves mention. One of the outstanding achievements of the Federal Reserve in Washington and at the regional banks is the high level of integrity and purposefulness of the principals and the staffs. More than ninety years passed without major scandal. There are very few examples of leaked information. This fine record has been abused rarely. Although I find many reasons to criticize decisions, I praise the standards and integrity of the principals.

    Volume 2 records some successes and achievements but many persistent errors. As in the earlier volume 1, I let the principals explain their reasoning. Much of the material uses the records of meetings of the Federal Open Market Committee. The Federal Reserve refers to these records as transcripts or memoranda of discussion. I refer to them as minutes. They find officials explaining their decisions many times but also showing an understanding of their mistakes and the reasons they continued.

    It took six or seven years to complete this volume. To write a volume with such enormous detail I needed much help. It would have taken much longer without the support of the bright and energetic assistants who read and summarized the minutes and provided assistance in collecting data and searching archives. I thank the nine assistants who worked at different times on the volume for their often insightful contributions. Thanks to Matt Kurn, Mark de Groh, Richard Lowery, Randolph Stempski, Jessie Gabriel, Jonathan Lieber, Hillary Boller, Daniel Rosen, and Danielle Hale. I regard their efforts as indispensable. They were supported and assisted by the helpful library staff at the Board of Governors. Thanks are due especially to Susan Vincent and Kathy Tunis, who guided me and many assistants through the records, and thanks also to David Small, Debby Danker, and Normand Bernard of the Board’s staff for their help and support.

    To supplement the Board’s records, I read the papers and records at the Federal Reserve Bank of New York. The reserve banks are not subject to the Freedom of Information Act. I am grateful to President William McDonough and to the archivist Rosemary Lazenby and her successor Joseph Komljenovich for making the records available and for their assistance and guidance through their extensive files. With the passage of time and the changed positions of Washington and New York, meetings of the New York directors became a less important source of information. The papers of the presidents and correspondence remained valuable.

    Presidential libraries were a more important source of material after 1951. No one can read these volumes without seeing the influence of politics and politicians. Papers of presidents, presidential assistants, and other officials contain records of policy development and conflicts. I benefited from the able assistance of archivists and librarians at the Millar Center at the University of Virginia, the Missouri Historical Society for the papers of William McChesney Martin, Jr., the Kennedy Library in Boston, the Johnson Library in Austin, the Carter Library in Atlanta, the Ford Library at the University of Michigan in Ann Arbor, and the National Archive II for the Nixon papers and the Nixon Oval Office tape recordings.

    To supplement the written records and documents, I interviewed several participants. All of the following graciously gave their time and interpretations. They were particularly helpful in describing the atmosphere in which decisions were made or rejected. I am grateful to each of the following: Steven Axilrod, Andrew Brimmer, Joseph Coyne, David Lindsey, Kenneth Guenther, Jerry L. Jordan, Sherman Maisel, William Miller, James Pierce, Charles Schultze, George Shultz, and Paul Volcker.

    Sherman Maisel permitted me to use the diary that he kept during his years as governor. These were very helpful and, as instructed, they are now deposited at the Board of Governors.

    On a visit to the research department in May 2003, I discussed the meaning of Federal Reserve independence with Governor Donald Kohn, Athanasios Orphanides, and Edward Ettin. Their comments helped me to understand how Board members and their staff regard this central concern of any monetary authority.

    Along the way, I had the good fortune to have several readers who commented on drafts of the main chapters, in some cases on all of them. I am especially grateful to Marvin Goodfriend, David Lindsey, and Anna Schwartz, who read and commented helpfully and extensively on all of the historical chapters. Jerry Jordan, David Laidler, Athanasios Orphanides, and Robert Rasche made insightful comments on several chapters. Responsibility for accepting comments and for remaining errors or misunderstandings are, of course, mine.

    Much of the archival material is in Washington. Without my long association with the American Enterprise Institute and its support for me and the many assistants named above, this work would not have been completed. I thank especially Chris DeMuth and David Gerson for their support. I benefited also from the support of the Tepper School at Carnegie Mellon University.

    Several foundations provided support. I am especially grateful to my friend Richard M. Scaife for his many contributions and to the Sarah Scaife Foundation. The Earhart Foundation, the Lynde and Harry Bradley Foundation, and the Smith Richardson Foundation also gave helpful assistance. Thank you.

    Alberta Ragan typed, proofread, and revised the manuscript several times. Her cheerful, capable, and willing assistance made completion much easier.

    Finally, I owe much to my wife, Marilyn, whose support and encouragement were never in doubt and always present.

    ONE

    Introduction

    Exact scientific reasoning will seldom bring us very far on the way to the conclusion for which we are seeking, yet it would be foolish to not avail ourselves of its aid, so far as it will reach:—just as foolish would be the opposite extreme of supposing that science alone can do all the work, and that nothing will remain to be done by practical instinct and trained common sense.

    —Marshall, 1890, 779, quoted in Blinder, 1997, 18

    The Federal Reserve that we find in these volumes is very different from the institution founded in 1913. Carter Glass, one of its founders, always insisted it was not a central bank. Its main business was the discounting of commercial paper and acceptances governed by the real bills doctrine and subject to the gold standard rule. The United States was an industrial economy, but agriculture retained a significant role and furnished about 40 percent of exports. Discounting facilitated the seasonal increase in loans that supported agricultural exports.

    By the 1980s, when this volume ends, the United States had become a postindustrial economy, by far the largest economy in the world. The Federal Reserve was the world’s most influential central bank. No one had denied it this title for at least fifty years. Much had changed. Discounting became a minor function. The gold standard was gone. Principal central banks issued fiat paper money and floated their exchange rates.

    During its early years and for many years that followed, the Federal Reserve System’s concerns included par collection of checks and System membership. Many small banks earned income by charging for check collection. The payee received less than the face amount of the check. Members were required to collect at par. Many small, mainly country, banks did not join the System to avoid par collection and to avoid costly reserve requirement ratios. Both problems ended by the 1980s when Congress made all banks adopt Federal Reserve reserve requirement ratios even if they declined membership.

    The most significant change was increased responsibility for economic stabilization, a mission that officials first denied having. Two economic and political forces changed that belief. One was developments in economic theory beginning with the Keynesian revolution in the 1930s and later the monetarist counterrevolution in the 1960s and the Great Inflation of the 1970s.

    The principal monetary and financial legacies of the Great Depression were a highly regulated financial system and the Employment Act of 1946, which evolved into a commitment by the government and the Federal Reserve to maintain economic conditions consistent with full employment. The Employment Act was not explicit about full employment and even less explicit about inflation. For much too long, the Federal Reserve and the administration considered a 4 percent unemployment rate to be the equilibrium rate. The Great Inflation changed that. By the late 1970s, the targeted equilibrium unemployment rate rose and Congress gave more attention to inflation control. The resolution was reinterpretation of the Employment Act as a dual mandate to guide policy operations at the end of the last century and beyond. The guide does not clearly specify how a tradeoff between the two objectives—low inflation and a low unemployment rate—should be made when required. But it is now more widely accepted that in the long run, employment and unemployment rates are independent of monetary actions, so that monetary policy is fully reflected in the inflation rate and the nominal exchange rate.

    The founders of the Federal Reserve intended a passive but responsive institution with limited powers. Semi-independent regional branches set their own discount rates at which members could borrow. The borrowing initiative remained with the members. Creation of the Federal Reserve brought regional interest rates closer together. By the mid-1920s, the System became more active. Under the leadership of Benjamin Strong, it initiated action to induce banks to borrow or repay lending. From this modest start, open market operations became the Federal Reserve’s principal and usually only means of changing interest rates and bank reserves. Discounting almost disappeared; advances became a very small activity used mainly for seasonal adjustment by agricultural lenders.¹ Following passage of the Employment Act, the Federal Reserve at first recognized responsibility mainly for employment and to a lesser extent for inflation. The weight on inflation increased in 1979, a result of the Great Inflation.

    Like most central banks, the Federal Reserve avoided taking risk onto its balance sheet. Until 2008 both by statute and by its own regulations, it limited the assets it acquired principally to Treasury securities, mainly short-term bills, and gold (or gold certificates after 1934) and foreign exchange. Originally the Federal Reserve tried to develop a market in bankers’ acceptances, but it did not succeed. In 1977, it ceased open market operations in bankers’ acceptances. Under pressure from Congress to assist housing finance, it purchased small volumes of agency securities in the 1970s.²

    Small and Clouse (2004, 36) reviewed the legal and regulatory rules that apply to the Federal Reserve’s asset portfolio.

    In usual circumstances, the Federal Reserve has considerable leeway to lend to depository institutions, but a highly constrained ability to lend to individuals, partnerships, and corporations (IPCs). The lending to depository institutions can be accomplished through advances (rather than discounts) secured by a wide variety of private-sector debt instruments. In discounts for depository institutions, the instruments discounted generally are limited to those issued for real bills purposes—that is agricultural, industrial, or commercial purposes. The Federal Reserve can make loans to IPCs, but except in unusual and exigent circumstances, the loans must be secured by U.S. Treasury securities or by securities issued or guaranteed by a federal agency.³

    The evolution that changed an association of semi-independent reserve banks into a powerful central bank reflects interaction between policy, events, and monetary theory. Volume 1 showed the importance of the gold standard and, even more, the real bills doctrine that had a powerful role in sustaining the Great Depression. This volume documents the role of Keynesian thinking in creating the Great Inflation and mainly monetarist thinking in bringing inflation back to low levels.

    Intervention between monetary theory, policy, and events is one part of the story. Changing beliefs about the role of government is another. By the middle of the twentieth century, citizens (voters) in all the developed countries accepted that government had a responsibility to maintain economic prosperity. This raised a critical issue. Voters could punish an administration or Congress for actions of the Federal Reserve. Responsibility and authority remained separate.

    The next sections discuss three main themes of this volume. First is the relation of monetary theory to monetary policy. Second is the meaning of central bank independence. Third is inflation, the dominant monetary event of the years 1965 to 1985.

    The monetarist-Keynesian controversy had a large role in bringing about changes in policy. Federal Reserve officials never agreed upon a theoretical framework for monetary policy, but the controversy and research influenced them. In the 1980s, Chairman Volcker called his framework practical monetarism. This was a major change from the approaches advocated by Chairmen Martin and Burns. Changing views about the meaning of central bank independence and its practical application contributed to the start, persistence and end of the Great Inflation.

    THE KEYNESIAN ERA

    In the early postwar years, policymakers assigned a major role in stabilization policy to fiscal actions. Monetary actions had a minor supporting role, mainly to support fiscal generated expansions or contractions by avoiding large changes in interest rates. Herbert Stein (1990, 50) listed the seven assumptions used in the early postwar versions of Keynesian economics. Stein described these assumptions as the simple-minded Keynesianism that a generation of economists learned in school and which became the creed of modern intellectuals.

    1. That the price level was constant, so that demand could be expanded without danger of inflation.

    2. That the potential output of the economy, or the level of full employment, was given—that it would not be affected by the government’s policy to maintain full employment.

    3. That we knew how much output was the potential output of the economy and how much unemployment was full employment.

    4. That the economy had a tendency to operate with output below its potential and unemployment above its full employment level.

    5. That output and employment could be brought up to their desirable levels by fiscal actions of government to expand demand—specifically by spending enough or by running large deficits.

    6. That we knew how much spending or how big deficits would be enough to achieve desired results.

    7. That there was no other way to get to the desired levels of output and employment, the main implication of which was that monetary policy could not do it.

    To economists in the twenty-first century, these assumptions and claims seem extreme, simplistic, even simpleminded. Three citations suggest how broadly it was held. First is the survey of monetary theory written for the American Economic Association’s sponsored Survey of Contemporary Economics (Villard, 1948). Second is the 1959 report of the Radcliffe Committee in Britain, written after inflation had become a problem in Britain, the United States, and elsewhere (Committee on the Working of the Monetary System, 1959). Third is the American Economic Association’s Readings in Business Cycles (Gordon and Klein, 1965). I cite these studies not because they were unusual but because they reflect the dominant or consensus views found in professional discussion, in popular textbooks such as Ackley (1961), and in econometric models of the period.

    Simple Keynesian ideas dominated the analysis in Employment, Growth, and Price Levels prepared by professional economists for Congress in 1959(Joint Economic Committee 1959a). The report denied long-run monetary neutrality, gave no attention to expected inflation, and argued that the economy could not on its own achieve full employment and price stability without guideposts for wages and prices. Chairman William McChesney Martin, Jr., did not share this view, and the Federal Reserve’s statement to Congress did not endorse it.

    The Federal Reserve opposed securities auctions and helped to finance budget deficits, a main source of inflationary money growth after 1965. Treasury later began auctions. In time, the Federal Reserve ended even keel operations used to reduce interest rate changes during Treasury financings.

    The early Keynesian model evolved. By the 1960s a Phillips curve relating some measure of inflation to output, the gap between actual and full employment, or unemployment became a standard feature. Prices no longer remained constant; aggregate demand could exceed full employment output, resulting in inflation.

    What remained unchanged was the belief that money growth had at most the secondary role of financing deficits or fiscal changes to prevent interest rates from rising, or from rising unduly. Policy coordination became an accepted policy program in the 1960s. In practice, coordination meant that monetary expansion financed government spending or tax reduction and also moderated the negative effects on employment of anti-inflation fiscal actions.

    There is often not a close connection between academic research findings and recommendations and Federal Reserve actions. This was certainly true of the 1950s. Chairman Martin had little interest in economic theory or its application. His principal advisers, Winfield Riefler and Woodlief Thomas, revived a modified version of the 1920s policy operations that gave main attention to the short-term interest rate and credit market conditions. To mask its role in affecting interest rates, the Federal Reserve most often set a target for free reserves—member bank excess reserves net of borrowed reserves. Free reserves moved randomly around short-term interest rates.

    Keynesian influence became much more visible in the 1960s. President Kennedy brought leading Keynesian economists into the administration. They continued the regular meetings, started in the Eisenhower administration, that brought the Federal Reserve chairman together with the president and his principal economic advisers. These meetings and other contacts sought to increase policy coordination and reduce Federal Reserve independence. And Presidents Kennedy and Johnson chose members of the Board of Governors who shared mainstream Keynesian views. As older staff retired, the Federal Reserve staff and advisers acquired younger economists trained in Keynesian analysis. By the late 1960s, the Keynesian approach dominated discussion.

    Similar changes affected Congress. Avoiding recession became the priority. Hearings reflected the urgency felt by many to avoid an unemployment rate above 4 percent, considered full employment.

    Chairman Martin at the Federal Reserve did not share these interpretations. He had a restricted view of both Federal Reserve independence and the power of monetary policy. To him, the Federal Reserve was independent within the government. This meant that Congress voted the budget. If they approved deficit finance, the Federal Reserve’s obligation called for monetary expansion to keep interest rates from rising. Martin blamed the deficit for inflation. As he said many times, he did not understand money growth. Thus, he permitted inflation to rise despite his many speeches opposing the rise. Although he did not share the Keynesian analysis, he enabled their policies.

    Federal Reserve policy relied on interest rate ceilings (regulation Q) to control credit expansion. Substitutes for bank credit developed to circumvent regulation. The euro-dollar market enabled banks to service their customers and money market mutual funds substituted for time deposits. Governor James L. Robertson especially recognized that the System should end reliance on rate ceilings, but the timing never seemed right. Opposition in Congress contributed to the lack of action. Also, the Federal Reserve did not distinguish between real and nominal rates, a problem after inflation rose. Brunner and Meltzer (1964) formalized the Federal Reserve’s analysis.

    THE MONETARIST CRITIQUE

    Clark Warburton was an early critic of Keynesian analysis.⁵ Warburton concluded from his empirical work that erratic changes in money growth were the main impulse producing recessions. Real factors had a secondary role. In the long run, money was neutral.

    One of the earliest propositions of monetary economics, expressed in the quantity theory, claimed that the monetary authority determined the stock of money, but the public determined the price level at which the stock was held. In a modern economy with developed asset markets, an excess supply of money increases the demand for existing assets in addition to or in place of increases in commodity demand. Higher asset prices induce increased demand for investment.

    Beginning in the mid-1950s, Milton Friedman and his students and collaborators produced theoretical and empirical analyses of the role of money. In Studies in the Quantity Theory of Money (1956), Friedman challenged the Keynesian view that money substituted only for bonds or, in practice, Treasury bills. In the most developed Keynesian models, wealth owners optimized their portfolio of bonds and real capital, then separately distributed short-term holdings between money and Treasury bills (Tobin, 1956 and elsewhere). Friedman treated money as part of an intertemporal portfolio; money holding substituted for bonds, real capital, and other stores of wealth as in classical analysis. The effect of changes in the stock of money were not limited to the interest rate on Treasury bills. Relative prices on domestic assets and the exchange rate or foreign position responded to the change in money.⁶ In their Monetary History, Friedman and Schwartz (1963) showed that money growth had a major role in fluctuations, inflation and deflation.

    Discussion and controversy went through several phases. Among the central issues were the properties of the demand for money, the distinction between real and nominal interest rates, real and nominal exchange rates, and between the short- and long-run Phillips curves.⁷ By the late 1970s, economists reached a consensus on many of the disputed issues. In his presidential address to the American Economic Association, Franco Modigliani, a leading Keynesian economist, acknowledged that the monetarist position was correct on these issues (Modigliani, 1977). The principal remaining issue between monetarists and Keynesians that he did not concede was whether monetary policy should follow a rule or proceed according to the discretionary choice of officials. Issues no longer in dispute included the long-run neutrality of money, the effects of inflation on money wages, nominal interest rates, and exchange rates, and any permanent real effects of inflation. Four fundamental issues affecting monetary policy remained: the role of monetary rules, the definition of inflation, importance of relative prices in the transmission of monetary policy, and the internal dynamics of a market economy, particularly whether it is mainly self-adjusting.

    Rules

    Classical monetary policy was based on rules. The best-known rule was the gold standard, but other proposed rules included bimetallism, commodity standards, and real bills. The aim was to achieve price or exchange rate stability. Keynesian analysis shifted the emphasis from rules to discretionary actions by governments and central bankers. Monetary policy, at first, had the modest role of financing fiscal actions, as discussed above. Its responsibilities increased until it held a prominent role in stabilizing the economy. Discretionary actions intended to stabilize were based on judgments of current and possibly longer-term consequences of events and policy actions.

    Early in the discussion of rules and discretion Friedman (1951) recognized the importance of information and uncertainty in choosing between a rule and discretionary actions. A well-intentioned policymaker may destabilize if he is misled by incomplete or incorrect information. Later work by Kydland and Prescott (1977) and a large literature that followed analyzed time inconsistency and the credibility of policy actions and announcements. Kydland and Prescott showed that the dynamic path that the economy follows depends on the choice of policy rules. A discretionary policy that made an optimal choice today was time inconsistent if it did not follow a rule restricting future actions. An individual or firm planning its future actions experienced increased uncertainty when faced by discretionary policy.

    A major change in economic theory came with recognition of uncertainty and the role of information. This heightened attention to the role of expectations. Lucas (1972) developed earlier work on rational expectations.⁸ Rational expectations raised a question about the meaning of discretion. In practice, many central banks responded by providing more and better information about current and future actions. Rational expectations implies that central banks depend on market responses and markets depend on central bank actions. Setting and achieving a target for inflation two or three years ahead is a recognized way of reducing uncertainty about future actions. Federal Reserve officials have not adopted a formal inflation target, but, for a time, they encouraged a belief that they try to hold inflation in the 1 to 2 percent range, and in 2007 they began to forecast inflation, output, and unemployment for three years ahead. In early 2008, however, they gave most weight to forecasts of possible recession and less weight to inflation.

    These actions constitute a major change from the secrecy traditionally practiced by central banks. It recognized the developments in monetary theory about the role of information, the importance of anticipations, and the success achieved by foreign central banks that announced inflation targets. But United States governments have not adopted fixed rules and are unlikely to do so in the foreseeable future.

    Central bankers continue to meet regularly to decide current actions. Prominent central bankers have explained why they do not commit to a fixed rule. The former chairman of the Federal Reserve, Alan Greenspan (2003), explained that a fixed rule could not take account of the many contingencies to which monetary officials might wish to respond. The contingencies are infinite and most are unforeseeable. Many of the contingencies arise from actual or potential financial failures. The monetary rules developed in the literature do not incorporate these contingencies. In the past, following Bagehot (1873 [1962]) the central bank or the government announced in advance that it would suspend the gold standard rule at such times and provide the increased reserves demanded. This became part of the monetary rule.

    Greenspan’s successor, Ben Bernanke (2004), recognized that the central bank can do a great deal to reduce uncertainty about its future actions, but specifying a complete policy rule is infeasible (ibid., 8). He accepted Greenspan’s reason for infeasibility. Mervyn King (2004), governor of the Bank of England, called for constrained discretion. Suitably designed, monetary institutions can help to reduce the inefficiencies resulting from the time-consistency problem (promising one thing but later doing another) (ibid., 1). Otmar Issing, former chief economist and board member of the European Central Bank, expressed a similar position on many occasions (Issing, 2003, for example). He regarded as impossible in practice the idea of following a fixed rule.

    The chapters that follow show that the Federal Reserve changed its objectives and its target many times. Often it did not have a precise target. Even after Congress required the Federal Reserve to announce an annual monetary target, it did not adopt procedures to achieve the target and allowed excess money growth to remain by following the practice called base drift.

    Table 1.1 from the 1980s shows the changing objectives pursued during 1985–88. The principal objective changed frequently, making it difficult for the public to plan. The Federal Open Market Committee (FOMC) did not announce the objectives at the time, and the statement of objectives was sufficiently vague that knowing the objectives would not help observers to anticipate policy actions. And because it chose four or five objectives, the public could only guess the relative importance of each or its influence on Federal Reserve actions.

    By the 1990s, principal central banks followed King’s constrained discretion. Many used some version of Taylor’s (1993) rule as a guide, but they deviated when they chose to do so. Several adopted inflation targets and gave more information about proposed actions and objectives. None followed a precise rule.

    Definition of Inflation

    Economists use two definitions of inflation, and laymen use some others. Monetarists define inflation as a sustained rate of change in some broad, general price index. The more common definition includes all price increases. Popular usage includes some relative price increases such as wage, asset price, or energy price increases; an example is wage inflation.

    Economic theory does not prescribe the choice of a stable price level over a stable sustained rate of price change. The former requires central bank policy to roll back or push up the price level following an event that raises or lowers it. If this is successfully carried out, the public can expect an unchanged price level over time. It incurs a cost because price adjustment is costly, particularly if the price level increased following a large increase in the price of oil or in an excise tax on a subset of goods.

    Table 1.1   Order in Which Policy Variables Appeared in the FOMC Directive

    Source: Economic Review, Federal Reserve Bank of San Francisco, Spring 1989, p. 11.

    The monetarist position lets the price level become a random walk. Energy price, excise tax increases, currency depreciation, or reductions in productivity raise the price level; opposite movements reduce the price level. These changes up and down often are spread through time. They appear as changes in the rate of price change, but they are not sustained.

    Sustained money growth in excess of output growth induces a sustained increase in the rate of price change. Milton Friedman’s often quoted statement that inflation is always a monetary phenomenon used the monetarist definition of inflation. It recognized implicitly that non-monetary price level changes are mainly relative price changes.

    A central bank must choose whether to control the price level or the rate of price change. Each has different costs to society. Controlling the sustained rate of price change permits the price level to vary, probably as a random walk. Wealth owners have to accept price variability but can be more confident when planning lifetime asset allocation that inflation will be controlled. Controlling all changes in the rate of price change also incurs a cost. The monetary authority must force other prices to decline if oil (or other) prices rise and permit other prices to rise in the opposite case. Such changes induce allocative changes and temporary changes in output and employment. Experience under the classical gold standard suggests that these costs are not small.

    In practice, some central banks ignore some transitory changes in the price level. The Federal Reserve targets the so-called core deflator for private consumption expenditures. This excludes changes in the prices of food and energy on grounds that these prices are volatile and that many of the changes are transitory. The public experiences the effects of food and energy prices and considers these changes as inflationary. In 2007 the Federal Reserve accepted responsibility for controlling these prices over the longer term.

    The use of a core price index is an inexact way of separating transitory from persistent price level changes to get a better measure of sustained inflation. A superior alternative would use statistical estimation of the relative variance of the permanent and transitory components to estimate whether a given change is likely to persist. Muth (1960) suggested a procedure.

    Persistent price changes—inflations—occur if sustained money growth rises in excess of sustained output growth. The inflation rate changes, therefore, if money growth rises relative to output growth or if normal output growth changes relative to money growth. The latter change occurred in the mid-1990s in the United States. It produced a fall in the sustained rate of inflation.

    Implementing a monetarist policy to control inflation requires commitment to the low or zero inflation rule. Implementation of the policy requires judgment about the permanent rates of change of money and output. Many central banks now use an inflation target that they try to meet over two or more years.

    The Role of Relative Prices

    The simple Keynesian model of the 1940 and 1950s had a single interest rate representing the bond market or, in practice, the Treasury bill or federal funds rate. In the IS-LM model of that period, money was a substitute for bonds; money growth had little direct impact on output or employment. The real balance effect was small. Usually the price level remained fixed. Later a Phillips curve avoided fixed prices by making the rate of price change depend on some measure of the output gap.

    Friedman’s (1956) essay on the demand for money broadened the interpretation of interest rates to include relative prices of assets and output. His analysis changed the explanations of the transmission of monetary impulses to include a wide range of substitutions between money and other objects. In place of the Keynesian transmission from money to Treasury bills found in textbooks and many versions of the Federal Reserve’s econometric models, monetarists claimed that changes in the quantity of money altered current and expected future prices on a wide variety of domestic assets and the exchange rate.

    In classical monetary theory, monetary policy changed the quantity of real balances relative to the stocks of other assets and current consumption. Substitution occurred in many directions. An excess supply of real balances induces changes in asset prices and spending; a deficient supply does the opposite. A change in the price of existing capital relative to the price of current investment induces or discourages new production. Changes in real balances relative to current consumption expenditure encourage or discourage spending.

    There is no possibility of a liquidity trap—a condition in which monetary changes are impotent. If the nominal rate on short-term bills falls to zero, this margin closes but other margins remain (Brunner and Meltzer, 1968). A central bank can always increase the quantity of real balances by buying long-term debt, foreign exchange, real assets, or claims to real assets until money holders find that they hold more real balances than desired. To reduce money holdings people spend on consumption or nonmoney assets, changing relative prices to restore portfolio balance.

    In Federal Reserve history, deflation occurred several times. In some periods, such as 1938, the nominal short-term interest reached zero or slightly below. Each of these periods is highlighted in the text of the two volumes. Economic expansion followed monetary expansion. Other periods of deflation, including the early 1920s, when the real interest rate reached 20 percent or more, do not show failure of monetary policy. The principal examples used by proponents of a liquidity trap are usually the early 1930s in the United States or the late 1990s in Japan. In both cases, monetary policy was not expansive. Inept and inappropriate monetary policy in 1929–33 induced reductions in money growth, giving rise to anticipations of further deflation.¹⁰

    The most comprehensive recent statement of modern macroeconomic theory, Woodford (2003), is an elegant, erudite development of the rational expectations model that currently dominates academic thinking. Like early Keynesian models, but for very different reasons, Woodford’s analysis has a single interest rate that is set by monetary policy. All other interest rates reflect the current short-rate and rational expectations of the duration, magnitude, and influence of current policies and events. Prices and output are determined by aggregate demand and supply. Since the single interest rate is fixed by policy action, money has no independent role. All relative prices fully reflect current rational expectations of future events. Spending in this and other models depends on the long-term real interest rate. The central bank controls the short rate. A strong assumption about the expectations theory or the term structure of interest rates assumes away the problem of determining long rates.

    Many central bank economists use this model. No central banker uses it. There are many reasons for this difference in approach. Three are most important.

    First, rational expectations models give importance to information and anticipations of future events. Decision makers use all available information when allocating resources. This is an important advance. However, few models recognize the cost of acquiring information and differences in this cost in different markets. Further, the meaning or interpretation assigned to observations depends on the particular model or framework used. Federal Reserve policy discussions show that major differences in interpretation and anticipations were common. Members lacked a common framework of analysis, so they often differed about the expected policy consequences of current information.¹¹

    Second, abundant econometric evidence suggests strongly that prices of long-dated assets have separate roles in the transmission of monetary policy. Considerable research shows that expectations theory of the term structure of interest rates does not hold at times. The relation of long- to short-term rates changes. The same is true of other asset prices and especially exchange rates. One reason is the market’s inability to estimate the term premium accurately. Different procedures give different estimates, often considerably different.

    Woodford (2005, 886–87) recognizes that long-term rates contain information useful to the Federal Reserve in interpreting its policy, but he concludes that a central bank could not affect the economy by purchasing long-term bonds even when the short-term rate is zero. The experience of the Bank of Japan after 2002 and on several occasions in U.S. history supports the opposite conclusion; expanding base money and money by purchasing longer-term securities stimulated spending with a zero short-term interest rate. Blinder (2004, 77) concluded that the implied interest rate forecasts (expectations) that can be deduced from the yield curve bear little resemblance to what future interest rates actually turn out to be. . . . Suffice it to say that the abject empirical failure of the expectations theory of the term structure of interest rates is a well-established fact.

    The distinction between sustained rates of change and changes in the price level is important for the term structure. Devaluation or an oil price increase raises the reported price level. If the increased oil price is expected to remain, the effect on interest rates is mainly at the short end. An increase in inflation expected to be sustained raises rates along the entire term structure.

    Third, to use the Woodford model, central bankers require reliable estimates of potential output and expected inflation. Research has shown that economists do not have such estimates and to date have not developed reliable estimates. This was a main reason for the large errors in predicting inflation in the 1970s, as Orphanides (2001) showed. And it is a main weakness of Phillips curve predictions of inflation and Woodford’s model.

    Role of Government

    Monetarists and Keynesians held different visions of the role of the government and the private sector. Following Keynes (1936), Keynesians viewed the private sector of the economy as unstable, subject to waves of optimism or pessimism that produced economic booms and recessions. Government had to act as a stabilizer, at first by changing its expenditures and tax rates and later by adjusting interest rates.

    Monetarists hold a contrary view. The internal dynamics of the private sector are stabilizing. Relative prices adjust to restore equilibrium. Declining tax collections and increased spending in recessions, built-in stabilizers, support recovery. Adjustment is not instantaneous, so government policy can nudge the economy toward equilibrium, but too often government policy worsens outcomes by doing too much or too little.

    A standard monetarist complaint about the Federal Reserve from the 1950s to the 1970s was that it misinterpreted its own policy. When short-term interest rates declined, the Federal Reserve interpreted the decline as easier policy despite a decline in money growth. And it interpreted an increase in interest rates as evidence of more restrictive policy even if money growth increased. Failure to distinguish between real and nominal interest rates until the late 1970s was part of the problem, but not the whole problem. Until 1994, monetary policy was typically procyclical until late in the inflation or recession.¹²

    The most damaging effect of the Keynesian belief in the role of government came after 1960. Administration economists argued that inflation would increase before the economy reached full employment output. Government had the role of limiting wage and price increases using guideposts and guidelines. This approach to pricing interfered in private decisions and, if successful, would have restricted prices and wages from reallocating resources efficiently. It concentrated attention on pricing in visible sub-sectors, especially those with strong unions. And it focused on price changes in those industries instead of general inflation.

    Keynesian economists and policymakers repeated this claim but did not produce evidence to support it. After 1980, the Federal Reserve abandoned the claim and insisted instead that stable low inflation abetted economic expansion and high employment. After inflation declined, the United States experienced three long peacetime expansions punctuated by relatively mild recessions. Low, relatively stable inflation contributed to this outcome. Researchers differ on the degree.

    Some monetarist analysis included a credit or financial market (Brunner and Meltzer, 1989, 1993, and 1968). This analysis recognized that money, government debt, and real capital are distinct assets held in portfolios. One function of financial markets is to allocate the stock of debt between banks and the public. This process is a factor in the determination of asset prices and interest rates. Recent work by Goodfriend and McCallum (2007) returns to issues involving intermediation and financial markets.

    Summary on Theory and Policy

    The two-way relation between monetary theory and policy was never complete or precise. The Federal Reserve and other central banks became more professional as time passed and complexity increased. Economists with academic training and experience occupied leading roles at central banks. Much larger staffs and more policymakers came from academic backgrounds. No chairman of the Board of Governors came from a professional economics background before 1970. After 1970 all but one had that training and experience. Nevertheless, analytic errors and misjudgments had a large role in mistaken policy choices.

    Cagan (1978a, 85–86) described the early postwar consensus on the role of money. The quantity theory of money was not considered important, indeed was hardly worth mentioning, for questions of aggregate demand, unemployment, and even inflation . . . [I]f you traveled among the profession at large, mention of the quantity of money elicited puzzled glances of disbelief or sly smiles of condescension.

    For very different reasons, the Federal Reserve ignored money growth until the mid-1970s, when Congress, over Arthur Burns’s objections, required semiannual statements that included ranges for money growth consistent with administration economic policy. William McChesney Martin, Jr., chairman from 1951 to 1970, had no interest in economic theory and did not find it useful. Until very late in his chairmanship, he prevented his staff from making forecasts. He often said that he did not understand statistics on money growth. He opposed attempts to control inflation by controlling money growth. In 1969, he replied to Milton Friedman, saying: I seriously doubt that we could ever attain complete control [of monetary aggregates], but I think it’s quite true that we could come significantly closer to such control than we do now—if we wished to make that variable our exclusive target. But the wisdom of such an exclusive orientation for money policy is, of course, the basic question (quoted in Friedman, 1982, 106).¹³

    Except for control of money, monetarist arguments prevailed eventually. The Phillips curve tradeoff vanished in the long run, as Friedman (1968b) predicted. Policy distinguished real and nominal interest rates and exchange rates. Long-run neutrality of money again became standard in economic theory. Strangely, models incorporating these ideas are now called neo-Keynesian (Ball and Mankiw, 1994).

    Romer and Romer (1994, 56–57) concluded their study of postwar macroeconomic policy by finding that monetary policy alone is a sufficiently powerful and flexible tool to end recessions. Contrary to the early Keynesian position, they found that fiscal actions contributed only moderately to recoveries . . . [T]he historical record contradicts the view that fiscal policy is essential to ending recessions or ensuring strong recoveries. However, the authors found that frequently monetary policy was destabilizing, and procyclical instead of counter-cyclical. This was a main monetarist criticism from the 1960s on.

    McCallum (1986) reviewed discussion of monetary and fiscal policy and critiqued criticisms of the Andersen and Jordan (1968) findings showing the relative and absolute importance of monetary policy for output. He concluded (McCallum, 1986, 23) that an open-market increase in the money stock has a stimulative effect on aggregate demand. This conclusion would not be remarkable if it had not been denied by early Keynesians and challenged by critics of the Andersen-Jordan paper.

    Modigliani’s (1977) conclusion that the monetarist position was correct on main issues of theory and fact represents an end to the controversy. He did not accept a monetary rule, and neither has the economics profession. Central banks continue to target interest rates, but they give much greater weight to avoiding inflation and damping inflationary expectations.

    Central Bank Independence

    Interpretations of central bank independence have changed several times. The changes were not limited to the United States. At the end of World War II, the British Labor government nationalized the Bank of England and made it subservient to the Treasury, that is to the elected government. Fifty years later, a new Labor government made the Bank independent. The Bank and the government now agree on an inflation target. With few restrictions, the Bank is empowered to decide on its actions. After years of inflation and slow growth, the government accepted the importance of price stability for economic growth and the importance of independence for price stability.

    The European Central Bank (ECB) requires governments to accept the independence of its member central banks. The ECB’s legal mandate is price stability, interpreted to mean sustained low inflation.¹⁴ Governments and ministers complain about the ECB’s actions, but they have not changed its mandate. Change requires unanimous agreement.

    The Federal Reserve Act gave the System independence that with few exceptions, as in wartime, administrations accepted until 1933. From 1933 to 1951, the Treasury Department dominated the Federal Reserve’s decisions, at first by direct pressure and in World War II and thereafter by agreement.¹⁵ Slowly after March 1951, the Federal Reserve regained some independence, but it remained responsible for assuring the success of Treasury debt sales. From 1961 to 1979, policy coordination, the emphasis given to avoiding recessions, and frequent Treasury debt sales restricted independence. The System gained increased independence for disinflation starting in 1979, and it retained its independence during the next quarter century. Testifying before a House subcommittee in 1989, Chairman Greenspan described independence as necessary to enable the central bank to resist short-term inflationary biases that might be inherent in some aspects of the political process (Greenspan, 1989, 2). Regrettably, the record does not show either a consistent avoidance of short-term pressures or avoidance of inflationary pressures from elected officials.¹⁶ Cukierman (2006, 149) points out the difficulty of not knowing the value of potential output as a source of error, possibly large error, in achieving an inflation target while maintaining actual output close to potential output. Orphanides (2003a, b) demonstrated the relevance of this point.

    Independence is never absolute.¹⁷ There are two principal, formal restrictions in the United States. First, the Federal Reserve is the agent of Congress. The Constitution gives Congress authority to coin money [and] regulate the value thereof; in principle, Congress can withdraw the authority or restrict Federal Reserve actions. On occasion, it has discussed such restrictions and in the 1970s, Congress required the Federal Reserve to report on its actions and plans. Second, the Treasury is responsible for international economic policy decisions. It can adopt a fixed exchange rate, requiring the Federal Reserve to intervene in the exchange market and to adjust interest rates and money growth consistent with the exchange rate target. On occasion, as in mid-1980s, the Treasury can agree on an exchange rate target, but the independent Federal Reserve sterilized most Treasury intervention. Table 1.1 above shows that it did not give priority to the exchange rate.

    Informal restrictions on independence vary. Members of Congress and of the administration urge the Federal Reserve to adopt policies that they favor. One example repeated in 1968, in 1982, in 1991, and at other times is pressure to reduce interest rates when Congress approves a tax increase. In 1968 and 1982 the Federal Reserve responded to this pressure. In 1991, following the Bush tax increase, the FOMC reduced rates to spur the economy.

    One manifestation of independence is budgetary authority. The government budget reports the System’s spending as an appendix and records a transfer of 90 percent of Federal Reserve earnings as a fiscal receipt. In the Banking Act of 1933, Congress accepted that the Federal Reserve’s receipts were not to be construed as government funds or appropriated moneys. This freed them from congressional budget control (Hackley, 1983, 2). Members of Congress have introduced legislation making the system subject to the congressional appropriation process or cancelling its debt holdings, thereby removing its source of income. The legislation has never passed, mainly because a majority prefers to maintain independence. In 1978, Congress approved the Federal Banking Agency Audit Act, providing for audit of some of the Federal Reserve’s transactions by the General Accounting Office. The act exempted transactions with foreign central banks and related to monetary policy actions (Hackley, 1983, 5). Since the Board lacks a source of earned income, the regional reserve banks pay an assessment to the Board.

    Other aspects of independence are the non-renewable fourteen-year terms of Board members, the absence of Senate confirmation for presidents of Federal Reserve banks, commercial banks’ ownership (but not control) of Reserve banks, the reluctance of Congress to approve legislation making the chairman’s term coterminous with the president’s, and service by Reserve bank presidents on the policymaking Federal Open Market Committee (FOMC). Other instances include the provision that Board members may be removed only for cause, and the removal of the Secretary of the Treasury and the Comptroller of the Currency from the Board in 1935. Congress has reconsidered each of these issues, some many times, but has not made a major change to reduce independence.

    Hackley (1972, 195) concluded that the Federal Reserve Board of Governors and the FOMC are agencies of the executive branch. It is a creation of Congress but so are other executive agencies. Hackley argues that the president appoints Board members and the Board, under congressional statutes, exercises governmental functions¹⁸ (ibid., 195). I have not found evidence that members of the Congressional Banking Committee share this view. Federal Reserve governors are asked frequently if they are the agents of Congress; the expected answer is yes.

    One informal but powerful restriction on Federal Reserve independence is its presence in Washington, the political capital. Board members, especially the chairman, are conscious of political developments and pressure to accede to them. Federal Reserve policy was an issue in the 1960 election and again in 1980. Arthur Burns as chairman was unusually partisan. He met with President Nixon regularly. Other chairmen and governors met at times with administration officials both at regular meetings and less formally. Pressure from Congress increased in the 2007–9 crisis.

    Several administrations used appointments to influence Federal Reserve decisions. On the other hand, some presidents honor independence. President Gerald Ford was exceptionally careful not to influence Arthur Burns. However, the minutes or transcripts of FOMC meetings contain very few references to politics. Partisan action would threaten independence, so it has usually been avoided.¹⁹ Wooley (1984, 109) concluded that presidents generally get the policy they want from the Federal Reserve. Presidents Ford, Carter, and George H. W. Bush would not accept that conclusion. It remains true that Presidents Eisenhower, Ford, Reagan, and Clinton were less intrusive than Presidents Johnson and Nixon. The result was lower inflation when the Federal Reserve was less subject to and less responsive to administration pressures.

    The monetary and political authorities have not agreed on a definition of independence. Often System officials speak about independence within government, a convenient phrase that recognizes that independence is not absolute but leaves open where the limits of government authority lie. The limits change. President Reagan wanted lower inflation and did not criticize Federal Reserve policy. His administration did not agree on what they wanted the Federal Reserve to do, so Chairman Volcker ignored them. He did not talk to Treasury Undersecretary Sprinkel and did not get along with Secretary Regan. The first Bush administration frequently criticized Federal Reserve policy publicly, and Chairman Greenspan publicly criticized as an attack on independence a letter written by a Treasury official to the FOMC members urging a reduction in interest rates. The Clinton administration did not discuss monetary policy publicly and avoided putting pressure on the System.

    In practice, the Federal Reserve waited for political support before making major policy changes. Although members chafed under the 2.5 percent ceiling for long-term rates before 1951, they did not challenge the restriction until they had congressional support. In 1978 polling data showed a sharp increase in concern about inflation that persisted until spring 1982. More than 50 percent of those polled listed inflation and the high cost of living as the most important problem facing the country. In October 1978, 72 percent listed inflation and only 8 percent listed unemployment. The public wanted disinflation; the political process responded and the Federal Reserve changed its policy. By October 1982, when the disinflation policy ended, 61 percent listed unemployment as the most important problem. Only 18 percent still cited inflation.

    President Nixon urged Arthur Burns to adopt more expansive policy prior to the 1972 election. Leading members of Congress agreed. The public expressed little concern about inflation. Only 20 percent listed inflation as their principal concern at election time.

    Independence should be strengthened. Responsibility for policy outcomes should not be avoided in discussions of independence. An independent central bank can cause unemployment or inflation. The public generally blames the administration and Congress for these outcomes. They may lose office. Federal Reserve officials may be criticized, but they retain their positions. Following the two major errors of the twentieth century, the Great Depression and the Great Inflation, no Federal Reserve officials had to resign.

    Responsibility and authority should be more closely aligned. At a Shadow Open Market Committee meeting in 1980, I proposed that the Federal Reserve Chairman and the Secretary of the Treasury should agree on the policy objective for the next two or three years. If the objective is not met, the president could ask for an explanation. He could then accept the explanation or ask for a resignation. Subsequently, several countries starting with New Zealand adopted variants of this proposal.

    Inflation

    The third major topic is inflation. Chapters 4 through 9 discuss four issues. Why did the Great Inflation start? Why did it take fifteen to twenty years to reduce inflation to low levels? Why did it end? Why did high inflation not return in the next twenty years?

    Modern central banks no longer claim, as the Federal Reserve did in the 1920s and even in the 1950s, that they do not control the inflation rate. They may have meant the near-term or quarterly rate but, if so, they failed to make that explicit. Academic research and experience settled the issue about the long term. It left open the practical issue of how to measure inflation and how to choose a value for an inflation target.

    Chairman Greenspan would not announce a numerical objective. He defined the absence of inflation as the point at which the public ignored inflation when making decisions.²⁰ President Poole of the St. Louis reserve bank favored a goal of zero inflation properly measured (Poole, 2005, 1). In practice, he proposed 1 percent inflation for an index that excludes volatile food and energy prices (ibid., 2).

    Poole’s definition recognized that in the short term, different indexes give different information. Over the longer term this is less of a problem. One reason is that one-time price changes and changes in relative prices distort inflation measures in the short term but are less troublesome over the longer term.

    Central banks that announce inflation targets choose measures of the sustained rate of price change. The price level is allowed to change in response to the many largely random changes in productivity, excise taxes, exchange rates, or other relative price changes. In economic textbooks, these problems do not appear. They are very real to central bankers.

    Otmar Issing (2003, 21) pointed to the information problem and the need for judgment. When analyzing expected inflation no simple rules linking policy to one or two privileged indicators can substitute for an accurate examination of shocks and a careful analysis of their potential for transmission into prices over a sufficiently extended span of time ahead. This statement about short-term difficulty in interpreting data contrasts with his view about the longer term. "Money should grow at a rate that is consistent with trend growth in real output and the central bank’s definition [sic] of price stability" (ibid., 21)

    One example of the difficulties that the Federal Reserve had in deciding on the expected rate of inflation came in 2002–3, when the FOMC became concerned about deflation. An economy with very large budget and current account deficits and positive monetary growth was unlikely to experience deflation. And the deflations in 1920–21, in 1937–38, in 1960, and at other times show no evidence that deflation had significant negative, real effects. The 1929–33 experience differed because money growth declined faster than deflation, suggesting that deflation would continue. The expected deflation did not occur in 2002–3.

    Orphanides (2001, 2003a, b) reported the errors in inflation forecasts during the 1970s. All the errors in the second half of the decade were underestimates of the inflation rate, strongly suggesting model errors. The Federal Reserve had difficulty forecasting the inflation rate at that time

    Enjoying the preview?
    Page 1 of 1