The Monetary Policy of the Federal Reserve: A History (Studies in Macroeconomic History)

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This has led central bankers to emerge as key architects of a market-based, transnational liquidity regime Gabor, ; Braun, a. These countries count as early adopters, prototypes and promoters of financialized capitalism see Helleiner ; Konings ; Krippner ; Green As Figure 1 shows, both countries experienced strong build-up of credit in their economies, beginning in the s and picking up pace in the s and s.

The widening gap we observe in both countries between the expansion of broad money dashed lines and credit solid lines indicates that this credit growth is increasingly due to market-based credit channels rather than traditional forms of credit intermediation through bank balance sheets. Measured as percentage of GDP growth during the same period, this indicates higher leverage ratios in the economy Taylor that are sustained by more fragile structures of liquidity Minsky ; Mehrling Credit to private non-financial sector from all sectors at market value; domestic currency; adjusted for breaks source: BIS total credit statistics.

We here concentrate on the role that innovations in money market techniques in the s and s played in aligning macroeconomic policy with these financialization processes. Surprisingly, there has been much less interest in, and discussion of, money market techniques in Britain, even though radical changes in these techniques during the respective period crucially altered the nexus between macroeconomic policy and finance. For that reason, we investigate the British case by drawing on our own study of archival sources and on oral history interviews.

Each of these explanatory factors can be shown to matter at different points in time and for different decisions taken. Through experimentation and accident, central bankers discovered that reconciling these conflicting imperatives required novel abstractions that would redefine the linkage between techniques of monetary governance and market structures through which Fed-policy works.

As it turned out, these abstractions needed to prescind from credit growth and financial inflation for this new pragmatic regime to work.

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The British case provides complementary insights on these processes because, still in the s, we find a very different institutionalization of economic and financial governance in the UK, based on fragile compromises between the Keynesian state and the old City elite. The crisis in this regime then produced an extended period of conflict between the programmes, rationalities and technologies of governing which was not resolved, but rather aggravated, during the heydays of Thatcherite neoliberal reforms.

Only in the s did the Bank of England introduce operative abstractions into the conduct of macroeconomic governance which would align policy programmes with the changing structures of UK banking. This process also required a pro-active remaking of the very markets used for monetary policy implementation.

The British case thus demonstrates particularly well that the operative, technical reconfigurations discussed in this article transcend the boundaries between what are usually understood as separate, public and private, realms. We proceed as follows: we first analyze the US case and discuss the pivotal role played by Volcker in guiding monetary policy out of the s dilemmas and into a world with elastic liquidity and low inflation Section 2.

We then discuss Great Britain as a complementary case, which allows us to demonstrate that the introduction of inflation targeting went hand-in hand with the wholesale endorsement of unfettered markets and thus implied a broader shift in institutional settlements between finance and the state Section 3.


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We conclude our article with a comparative discussion of the insights gained from our two case studies. On this basis, we briefly develop the implications of our analysis for current discussions on regulating finance, and the role and shape of monetary policy in these efforts Section 4. Due to the global spread and dominance of US economics Fourcade, , both modern practice and theoretical reflections of central banking bear, in many ways, the traces of US historical experience and institutional evolution.

By tracing the genesis of the specific translation of political programmes through operative techniques that the Volcker experiment initiated, we are able to make visible how a symbiotic relationship with financialized market structures became inscribed into the very organizational practices of central banking. With refinancing and liquidity in non-crisis conditions dependent on a pool of scarce reserves gold , banks were institutionally constrained to carefully gauge their longer-term costs of refinancing as a function of their present demand for scarce liquidity.

As long as the extension of credit was endogenously constrained by the need to procure reserves, the tight integration of money and other financial markets meant that financial speculation directly fed into the money market interest rate, creating a potential control relation for monetary policy to exploit.

This, in turn, would attract further reserves previously employed in other sectors, resulting in a cumulative process until available reserves were exhausted. To break this cumulative process and to prevent, first, the propagation of funding cost-push inflation through the economy, and finally the deflation that followed it , monetary policy thus needed to cut the link by which initial financial speculation attracted the reserves required for its own continuation from other sectors.

Instead of exogenously adjusting the pool of reserves on which market liquidity ultimately rested, central banking thus became an endogenous provider of market liquidity itself Meltzer, , pp. This meant that the nominal anchor that had enabled market participants to gauge their longer-term costs of refinancing as a function of their expected demand for liquidity was no longer provided by the institutional structure of the market.

The discount rate at which the Fed backstopped the market absorbed the market interest rate, whose role otherwise would have been to coordinate intertemporal allocation in real cost terms. During the period of Keynesian demand management, this had the advantage of turning the interest rate into a direct lever for affecting growth and un- employment. The increasing integration of the financial system magnified the recessionary impulse from any attempt to discipline credit. These contradictions moved to the surface during the s Meltzer, , pp. Experimenting with other quantity indicators than the increasingly irrelevant free reserves, the Fed found itself in a double bind: on the one hand, it would have needed to move the discount rate vigorously in order to credibly establish the threat of a nominal anchor.

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As Krippner shows, practitioners were intensely skeptical of the possibility of accurately controlling the money supply Brimmer, [] , but acquiesced to the pressure to adopt the idiom, eventually learning to appreciate its usefulness for cloaking unpopular policy choices Krippner, , p. While, in the short term, Monetarism proved useful as political cover for the high interest rate required to break inflation expectations, in the longer run it provided the technical frame required for a re-abstraction of monetary policy that integrated programmes, rationalities, and technologies into a durable pragmatic regime.

He used the workhorse Keynesian IS-LM model to provide a diagnosis of the ongoing cumulative process as resulting from the endogeneity of market expectations. In line with the logic of excess or free-reserves targeting, the Fed thus sought to signal constraint by varying the price of excess reserves rather than pursuing an inflexible money supply target that could have disrupted markets. As a mode of re-articulating monetary policy strategy and implementation, monetarism provided a form of abstraction that promised to resolve this conundrum.

By operatively tying its use to a background system of abstractions in terms of monetary quantities, its intended meaning could be affixed to the movements of and relations between these quantities. This would provide a firm and credible, exogenous nominal anchor for markets to decipher discount rate signals. It is against this backdrop that the quantity-theoretical idiom could unfold its full performative power.

At the same time, internally, it would guide a process of re-articulating and re-aligning operative procedures and abstractions with market structures in a way that avoided the contradictions that had come to be tied to the short-term interest rate as policy conduit. To achieve this, Volcker instituted a complex and sophisticated shift in monetary policy procedures.

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Non-borrowed reserves targeting worked by projecting a desired overall money growth path. Considering how recent past volumes of bank borrowing had diverged from this projected path, the Fed would provide targeted short- and medium-term volumes of non-borrowed reserves through open market operations. The market interest rate that emerged from this and the eventual volume of discount window borrowing thus could serve as indicators for both the Fed and banks to correct their decisions so as to achieve a smooth convergence on the desired path. The sheer complexity of this arrangement means that it is open to multiple interpretations.


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This anchor worked by virtue of sequencing. In the first stage, the Fed would establish the credibility of its fictional anchor by allowing interest rates to rise. Crucially, this credibility did not depend on actually imposing a biting liquidity constraint, but only on generating an observable price-effect as a consequence of more restrictive open market trading.

Much like in the free-reserves doctrine, increased recourse to discount borrowing was thus seen as indicative of monetary restriction Volcker, Credibility tests recurred, and one of the primary concerns for the Volcker-Fed was to pass these tests Goodfriend, , p. By disentangling the discount rate the Fed thus hoped to encourage an intertemporal calculation of refinancing costs as if a nominal anchor was in effect—and thus to tackle the twin problems of interest rate smoothing and base drift.

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The price for making these abstractions work, however, was that the Fed had to stop worrying about credit growth. Monetarism thus proved useful to the extent that it provided a blueprint for disentangling the discount rate as a policy tool from market expectations regarding longer-term refinancing conditions, by creating a background of interacting monetary quantities as a nominal anchor for interpreting the signals sent via this lever.

But as long as credit remained inscribed by indicators of monetary growth into the operative abstractions in terms of which the technologies of governing of this novel pragmatic regime were designed, its continued growth weakened the very control relations the Fed sought to exploit Hetzel, ; Goodhart, In order to gain a robust functional relationship between policy lever and inflation, the substantive coupling to monetary quantities had to be abandoned. The Volcker experiment and its aftermath precisely illustrate the point that the price for having a technology that was effective in day-to-day operations was to decouple it operatively from the behavior of monetary quantities—although coupling it to them conceptually had paradoxically provided the initial inspiration for these operative reforms.

Though foreshadowing many of the abstractions integral to the inflation-targeting operative procedures that crystallized towards the turn of the following decade, the Volcker regime of — thus experienced some teething troubles. The instability of the relations between money supply targets and required interest rates, as well as the technical difficulties of anticipating the effects of a given reserve supply on these rates, produced considerable noise and volatility Hetzel, , Meltzer, The ensuing scramble for reserves contributed to the already developing instability of the money demand function Modigliani, , p.

But it also shifted credit growth to speculative uses, manifesting itself henceforth primarily in financial inflation while inflation in the real economy fell precipitously. The Fed, even under Volcker, could not override the technical and operative constraints arising from its acquired role as a central hub in the structures of liquidity of the financial system, which up to this point had undermined any attempt to achieve a stable and robust functional transmission relationship between bank rate, quantities and market rate.

However, the Fed got lucky. With credit growth manifesting itself in financial, not real-sector inflation, political pressure on the Fed to effectively constrain credit growth eased permanently.

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Having struggled with the entanglements of key operative variables analyzed above, central bankers became increasingly concerned with disentangling them in operational terms, and with developing instruments and techniques that allowed for stable and fine-tuned influence on operatively isolable targets Goodhart, , p.

The Volcker shock had demonstrated the limits of this disentangling; as long as credit growth remained included in the functional relationships presupposed as conduits for policy implementation, the articulation of a durable and robust technology for governing financial markets remained illusory. The switch to borrowed reserve targeting Wallich, , rather than being a simple return to interest rate targeting as is sometimes argued, amounted to an attempt to stabilize the interest rate and borrowed reserves levels Goodhart, , p.

However, this attempt to secure the monetary growth path without constantly disrupting the newly discovered stable relation between discount and inflation rates, failed.

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Serendipitously, the Fed had discovered in its operative practice another stable control relation that seemed to hold up after the switch to borrowed reserves targeting. Unexpectedly, the volatility of long-term interest rates had increased concomitantly with that of short-term rates during — Spindt and Tarhan, Market expectations as to future inflation rates as revealed in the term structure of the interest rate and the yield rates of government bonds seemed to react increasingly sensitively to the Fed adjusting the short-term interest rate, while consumer price inflation, not least as a result of the Volcker shock recession and the resulting shift of credit into the financial sector see Krippner, , remained comparatively low Hetzel, , p.

However, as the decade progressed, it became clear that the nominal variable that disciplined FOMC actions was the bond rate not money. Hetzel, , p. Though the Volcker framework itself had not produced a viable alignment of the programmes and technologies of government with the market structures through which they operated, it had installed a frame of abstraction which provided the basis for a reconfiguration of monetary policy that could. The Fed, despite legally remaining obliged to establish money growth targets, phased out operative and public reference to them beginning in the mids in response to the breakdown of viable instrument-target relations to exploit Friedman and Kuttner, , p.

Instead, it seized upon the opportunity and began to experiment with procedures for exploiting and strengthening the relation between the money market rates, the long-term rate, and inflation expectations. Over the next decade and a half, the Fed then worked on improving the precision of its techniques of controlling the short-term interest rate and fine-tuning its communicative interactions with financial markets. The new objective thus was to improve its ability to better exploit the influence it apparently had over these market expectations and thus, indirectly, over the inflation rate in the economy.

In the longer run, liability management depressed demand for money to underpin credit expansion and thus also reduced the growth of the monetary base, at the cost of undermining its relation to nominal income and thus inflation. As a result, the policy rate was also freed from the task of actually constraining liquidity, removing one of the fundamental contradictions of pre-Volcker monetary policy.

The Fed could instead increasingly use its rate as a pure signaling device, as Volcker had initially intended. In the late 20th century, the Bank of England went through a radical transformation Goodhart, ; Singleton, In this decade, the Bank of England emerged as a powerful macroeconomic policy maker with considerable international prestige.

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