Goodfriend: Lessons from a Century of Fed Policy – Why Monetary and Credit Policies Need Rules and Boundaries


In 1913 the United States overcame a long-standing distrust of government intervention in the monetary system to establish a central bank. The Fed was to employ its independent monetary and credit policy powers to improve on the rules of the classical gold standard, rules that were seen as unduly restrictive. We now know that faith then placed in discretion over rules was misplaced. The independence given the Fed to pursue discretionary policy in the public interest proved counterproductive.

On the monetary policy side, in line with public and political pressures, the Fed’s inclination to prioritize low unemployment over low inflation produced go-stop monetary policy after World War II that delivered neither, and instead produced the Great Inflation and rising unemployment. The Volcker Fed disinflation in the early 1980s eventually brought both inflation and unemployment down, and showed that effective monetary stabilization policy needs the discipline of an interest rate rule based on a credible commitment to low inflation.

On the credit policy side, there has been since World War II a gradual relaxation of the Fed’s last resort lending discipline. Fed lending supported insolvent depositories in the 1970s and 1980s. And Congress in 1991 granted the Fed virtually unlimited power to lend beyond depositories in a crisis. Unbridled credit policy independence in conjunction with its financial independence drew the Fed into a massive expansion of credit in the 2007-09 credit turmoil with the “implied promise of similar actions in times of future turmoil.”

The lesson from the Fed’s first century is that wide operational and financial independence given to monetary and credit policy subjects the Fed to incentives detrimental for macroeconomic and financial stability. The paper tells the story.


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