The Fed at 100: Monetary Policy Performance and Lessons from a Century of Central Banking

1. The Fed at 100: Monetary Policy Performance and Lessons from a Century of Central Banking David 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.

2. 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?

3. 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).

4. 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

5. The Great Depression and Great Recession

6. Banking Crises Brought Deflation Second Banking Panic UK off gold standard Final Banking Panic Sources: National Bureau of Economic Research, Bureau of Labor Statistics & HaverAnalytics Last Observation: December 1933

7. The Fed’s Tepid Response to Crises Sources: Federal Reserve Board, Banking and Monetary Statistics 1914-1941 Last Observation: December 1934

8. 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.

9. Deflation Caused Nominal and Real Interest Rates to Diverge Real i = Nominal i – Inflation Rate Last Observation: December 1933

10. Recovery: No Thanks to the Fed Rapid 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

11. The Real Interest Rate and Business Investment Last Observation: 1941

12. M2 & Nominal GNP, 1929 - 1941 Sources: National Bureau of Economic Research & HaverAnalytics Last Observation: December Q4-1941

13. 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

14. More Mistakes: The Great Inflation Source: Federal Reserve Board, Bureau of Labor Statistics & Haver Analytics Last Observation: 1995

15. 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.)

16. Nominal & Real Interest Rates Source: Federal Reserve Board, Bureau of Labor Statistics & Haver Analytics Last Observation: December 1985

17. Phillips Curve 1959-68 & 1969-85 Unemployment Rate Unemployment Rate Source: Federal Reserve Board, Bureau of Labor Statistics & Haver Analytics Last Observation: 1985

18. 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)

19. 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

20. 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.