The Fed at 100: Monetary Policy Performance and Lessons from a Century of Central BankingDavid C. Wheelock

Vice President and Deputy Director of Research

Federal Reserve Bank of St. Louis

December 6, 2013

The views expressed in this presentation are not necessarily official positions of the Federal Reserve Bank of St. Louis or the Federal Reserve System.

End the Fed?

• The Fed’s response to the recent financial crisis was vigorous and controversial; monetary policy remains controversial Need to distinguish crisis response (lender of last resort) from

monetary policy response to the recession and beyond The Fed now views financial stability and monetary policy as

“coequal” responsibilities of the central bank (Bernanke, 2013).

• How has Fed policy been shaped by events in the Fed’s first 100 years, especially the Great Depression and the Great Inflation?

In the Beginning, Financial Stability was the Only Goal• The Fed’s founders sought to prevent banking panics by

“furnishing an elastic currency.” The Fed would “rediscount” commercial paper (loans) for

member banks in exchange for currency (Federal Reserve notes) and reserve deposits.

The Fed supplied currency and reserves passively (against acceptable collateral) to satisfy demand.

• The founders did not conceive of monetary policy as we think of it today. The gold standard and adherence to “real bills” principles would ensure an optimal money supply (i.e., support economic activity without inflation).

The Great Depression

• A successful first 15 years, 1914-29 No crises Price stability Federal Reserve credit eliminated the seasonal fluctuations in

interest rates The Fed learned to use open-market operations to influence

interest rates and achieve macro objectives, i.e., to conduct monetary policy

• But, then there was the Great Depression Banking panics returned Severe economic collapse with a prolonged recovery

The Great Depression and Great Recession

Period Length in Months

Real GDP: Percent Decline Peak to Trough

Unemployment: Max Value

During Recession

CPI: Percent Change Peak

to Trough

1929-33 43 -36.2% 25.4% -27.2%

2007-09 18 -4.7% 10.0% 1.6%

Banking Crises Brought Deflation

Sources: National Bureau of Economic Research, Bureau of Labor Statistics & Haver AnalyticsLast Observation: December 1933

1929 1930 1931 1932 193325

30

35

40

45

50

10

12

14

16

18

20

M2 (Left Axis)

CPI (Right Axis)

USD Billions Index, 1982-84=1001929 Crash

First Banking Panic

UK off gold standard

Final Banking Panic

Second Banking Panic

The Fed’s Tepid Response to Crises

1929 1930 1931 1932 1933 19340

500

1000

1500

2000

2500

3000

3500

4000

4500

5000Other Fed Credit

Federal Reserve U.S. Govt. Securities Portfolio

Federal Reserve Loans

Stock Market Crash

First Banking Panic

U.K. Off Gold Standard

Final Banking Panic

USD Millions

Sources: Federal Reserve Board, Banking and Monetary Statistics 1914-1941Last Observation: December 1934

Where was the Fed?

Fed officials misinterpreted financial conditions: They viewed a lack of discount window borrowing and low nominal interest rates as evidence of monetary ease.

However, the discount window was closed to nonmember banks, required collateral, and entailed stigma not a good signal of banking conditions

Deflation caused the real interest rate to rise, which increased the cost of borrowing and discouraged investment spending. Low nominal rates reflected a collapsing economy, not monetary ease.

Deflation Caused Nominal and Real Interest Rates to Diverge

Last Observation: December 1933

1929 1930 1931 1932 1933-2

0

2

4

6

8

10

12

14

16

Nominal

Real

Percent, 3-Month Banker's Acceptance Rate Real i = Nominal i – Inflation Rate

Recovery: No Thanks to the FedRapid money supply growth beginning in 1933 (Bank Holiday and deposit insurance ended banking panics; gold inflows increased the money supply; no Fed actions)

rising price level

falling real interest rate

increased spending

The Real Interest Rate and Business Investment

Last Observation: 1941

1929 1930 1931 1932 1933 1934 1935 1936 1937 1938 1939 1940 19410

2

4

6

8

10

12

-4

-1

2

5

8

11

14

USD Billions

Business Investment (Left Axis)

Real Interest Rate (Right Axis)

Treasury Bill minus Inflation Rate, Per-cent

M2 & Nominal GNP, 1929 - 1941

Sources: National Bureau of Economic Research & Haver AnalyticsLast Observation: December Q4-1941

1929 1930 1931 1932 1933 1934 1935 1936 1937 1938 1939 1940 194125

30

35

40

45

50

55

60

65

40

50

60

70

80

90

100

110

120

M2 (Left Axis)

Nominal GNP (Right Axis)

USD Billions USD Billions (SA)

Some Lessons from the Great Depression• Money matters

The central bank should respond aggressively to crises (lender of last resort);

The central bank should strongly resist deflation

• Financial crises can have serious macroeconomic impacts Recessions associated with financial crises tend to be more

severe than others and recoveries are sluggish More effort required to produce a vigorous recovery Regime changes may be needed to restore confidence in banks

and sustain recovery

More Mistakes: The Great Inflation

Source: Federal Reserve Board, Bureau of Labor Statistics & Haver AnalyticsLast Observation: 1995

1951 1955 1959 1963 1967 1971 1975 1979 1983 1987 1991 19950

1

2

3

4

5

6

7

8

9

10

0

2

4

6

8

10

12Inflation (Left Axis)

M2 Growth (Right Axis)

Percent Percent

Where was the Fed?

• Misled by nominal interest rates again – the real rate was low, sometimes negative, encouraging borrowing and spending. Monetary policy was not “tight.”

• Misled by the “Phillips Curve” – policymakers believed that unemployment could be reduced permanently by allowing a higher inflation rate.

• Incorrect ideas about the causes of inflation (budget deficits, oil shocks, labor unions, etc.)

Nominal & Real Interest Rates

Source: Federal Reserve Board, Bureau of Labor Statistics & Haver AnalyticsLast Observation: December 1985

1965 1967 1969 1971 1973 1975 1977 1979 1981 1983 1985-10

-5

0

5

10

15

20

Real Interest Rate

Nominal Interest Rate

Percent

Phillips Curve 1959-68 & 1969-85

Source: Federal Reserve Board, Bureau of Labor Statistics & Haver AnalyticsLast Observation: 1985

3 4 5 6 7 8 9 10 112

4

6

8

10

12

14Phillips Curve 1969-85

CPI Inflation Rate

1980

1979

1974 1981

1975

1978

1977

19821973

1970

1976

1983

1984

1985

1971

1972

1969

2 3 4 5 6 7 8-1

0

1

2

3

4

5

6Phillips Curve 1959-68

CPI Inflation Rate

1968

1966

1967

1965

1961

1959

1964

1960

1963

1962

Unemployment Rate Unemployment Rate

Lessons from the Great Inflation

• Inflation is a monetary phenomenon (just as deflation was a monetary phenomenon in the 1930s)

• The stance of monetary policy is reflected in the real interest rate, not the nominal rate (again, like the 1930s)

• No long-run tradeoff between inflation and unemployment Monetary policy cannot permanently lower the unemployment

rate (long-run monetary neutrality)

Lessons Learned? Policy in 2007-09

• “Lender of Last Resort” (financial stability) actions: Loan facilities for banks and other financial firms (TAF, PDCF,

etc.) Special facilities for specific firms (Bear Stearns, AIG) “Stress Tests” for the largest firms (made permanent)

• Monetary Policy actions: Cut interest rates (ultimately to zero) Forward guidance Treasury and MBS purchases (“QE”)

• No deflation; no depression

Looking Forward

• The Fed drew lessons from prior crises, especially the Great Depression, in 2007-09.

• With inflation low, the Fed has also apparently avoided the mistakes of the Great Inflation, but much of the history of the current episode remains to be written.