In the last article, we talked about the period of Great Inflation that led to the eventual collapse of the Bretton Woods system.
During this period of Great Inflation, the Fed failed to meet its mandate to keep inflation at steady and moderately low levels, thereby plunging the country into former financial difficulties. After this latest bump in the economic road, it’s no surprise that what came next was a series of reforms to fix the broken monetary system.
What should the central bank have done during this crisis to save the day?
It’s a tough question to answer.
First, let’s quickly review what we’ve discussed over the last few posts: when the Federal Reserve was first established in 1913, its founding purpose was to expand or contract the money supply and bank reserves in order to stem banking panics. This original mandate assumed the gold standard regime, which tended to keep inflation under control automatically since money supply can only expand as far as the existing supply of gold. But remember what came next?
After the Great Depression, Congress passed the Employment Act of 1946, which required the federal government “to promote maximum employment, production, and purchasing power.” The Federal Reserve was required to support the government’s efforts to meet its mandate, so the role of the Fed was indirectly expanded to also “promote maximum employment, production, and purchasing power.”
By the 1970s, the era of the gold standard was over (when the Bretton Woods system collapsed), and inflation skyrocketed. The US was faced with both inflationary pressures and slower growth.
The high inflation and unemployment of the 1970s, collectively referred to as “stagflation,” taught economists some hard lessons. This led to a series of reforms of how the Fed operates.
Ben Bernanke, who served as chair of the Federal Reserve from 2006 to 2014, commented on the subject in 2004:
“Unfortunately, monetary policy cannot offset the recessionary and inflationary effects of increased oil prices at the same time. If the central bank lowers interest rates in an effort to stimulate growth, it risks adding to inflationary pressure; but if it raises enough to choke off the inflationary effect…it may exacerbate the slowdown in economic growth.”
Bernanke noted that the decision to tighten or ease monetary policy ultimately depends on how policy makers balance the risks between pursuing low employment vs. stable inflation.
Below, we will learn about the different reforms that were made to how the Fed operates.
One of several reforms included the Reform Act in November 1977, which did several things.
The act created new mandates for the Federal Reserve. Specifically, the Fed was now required to ”maintain long run growth of the monetary and credit aggregates commensurate with the economy’s long run potential to increase production, so as to promote the goals of maximum employment, stable prices, and moderate long-term interest rates.
So the three policy goals the Fed now had were: employment, stable prices, and moderate long-term interest rates. The third goal — “moderate long-term interest rates” — is often not explicitly discussed. Former Federal Reserve Governor Frederic Mishkin explains that this is because:
“long-term interest rates can remain low only in a stable macroeconomic environment, these goals are often referred to as the dual mandate; that is, the Federal Reserve seeks to promote the coequal objectives of maximum employment and price stability.”
In other words, for long-term interest rates to be moderate, people must be employed, and inflation needs to be under control. So focusing on goals 1 and 2 automatically helps with goal 3.
More regulatory oversight
In addition to expanding monetary policy objectives, the Reform Act also required the Fed to be more transparent and accountable to Congress, such as by mandating semi-annual hearings before both the House and the Senate about the Fed’s objectives, performance, and plans. Moreover, the act limited the chairman and vice chairman of the Fed to four-year renewable terms.
The Reform Act also prohibited the Fed from discriminating against board directors on the basis of race, creed, color, sex, or national origin. Furthermore, while the original Federal Reserve Act of 1913 only required agriculture, commerce, and industrial interests to be represented, the Reform Act required representation of services, labor, and consumer interests as well.
Another big reform was the Humphrey-Hawkins Act.
Recall that the Employment Act of 1946 required the federal government to promote maximum employment, production, and purchasing power. In a 1976 hearing, Sen. Hubert Humphrey commented:
“It is my judgment that that law has, from time to time, been conveniently ignored”.
Humphrey felt the need to draft more explicit employment goals. Some time after the senator died, the Humphrey-Hawkins Act was signed into law by President Carter. The act requires that unemployment not exceed 3% for people 20 years or older, and mandates that inflation should be reduced to 3% or less. It also required that by 1988, the inflation rate should be 0% without interfering with the employment goal.
Depository Institutions Deregulation and Monetary Control Act of 1980
Other major reforms included the Depository Institutions Deregulation and Monetary Control Act of 1980. The goal was to deregulate banks and further improve the control of monetary policy by the Federal Reserve.
Why deregulate banks?
Up until this time, the maximum interest rate that banks and other institutions could pay on deposits was regulated by the federal government under what was known as “Regulation Q.” Banks were not allowed to pay any interest on checking accounts (or “demand deposit” accounts) and the rate on savings accounts at banks was set at 5.25%.
But given that the interest rates the market was paying (e.g., money market mutual funds) were in the double digits (e.g., short-term Treasury securities were offering over 12%), banks were at a disadvantage compared with less-regulated competitors. People who used traditional banks were effectively penalized by being denied a market rate of interest for their money.
This especially affected lower-income households who could not access sophisticated market alternatives (e.g., money market mutual funds) easily, so these households had much lower savings as a result. Overall, Regulation Q not only made saving less attractive for less fortunate households, but also reduced banks’ role in financial markets.
The Deregulation Act of 1980 phased out restrictions on interest rates that banks could offer. This allowed banks to compete in the market and it encouraged consumers to save more.
The Monetary Control Act of 1980 was another reform enacted to improve the control of monetary policy by the Federal Reserve. The act required all institutions that accepted deposits (“depository institutions”) to meet reserve requirements. Up until this time, only commercial banks that were members of the Federal Reserve System were required to hold reserves, and by 1980 less than 40% of banks were members. The other 60% of depository institutions (e.g., savings and loans and credit unions) didn’t have reserve requirements, yet their deposits were still counted towards the money supply. This was limiting the Fed’s ability to control the money supply.
The new Reserve requirements set forth by the act required all depository institutions to set aside a certain amount of funds in either cash or the accounts they keep at regional Federal Reserve Banks. The amount kept in reserve is based on the size of an institution’s deposits.
The Depository Institutions Deregulation and Monetary Control Act had major effects on how the Fed operates. Paul Volcker (who we’ll learn about in the next post!) noted the acts “will undoubtedly take their place among the most important pieces of financial legislation enacted in this century” (Federal Reserve Bank of St. Louis 1980).
Requiring all depository institutions to meet reserve requirements was especially important because it gave the Fed more control to fight inflation and help stabilize the economy. Deregulating enabled banks to compete and benefited consumers by increasing their savings. Other changes included opening up the discount window to all depository institutions, which helped level the regulatory playing field across financial institutions.
Reforms were a good first step, but the US was definitely not out of the economic woods yet. In the next post, we’ll learn about how Paul Volcker was a key figure in helping fight the Great Inflation. This period later became known as the Great Moderation and was a very uplifting time for the US (finally, some good news!). You know you want to read something cheerful, finally…so see you in the next post!
In previous articles, we’ve looked at factors leading up to the Great Inflation, which, as you may remember, was a period of turbulence in the US during the 1960s and 1970s. So what of the calm after the storm? Was there any? Fortunately, yes! Under the chairmanships of Paul Volcker (ending in 1987), Alan Greenspan (1987–2006), and Ben Bernanke (starting in 2006), there was a decline in the volatility of GDP growth and inflation. This led to the “Great Moderation”, a period of relative economic calm from the mid-1980s to 2007.
…Yes, you can probably see where this headed. The 2007–2008 financial crisis ended the calm of the Great Moderation. We’ll get to that in the next article, but first, let’s look at the Great Moderation itself. How did this time of economic calm happen? What can we learn from it?
Volcker comes to the rescue
When Chairman Paul Volcker took office, inflation was in the double-digits. Volcker promised to make lowering inflation his top priority.
His plan was to tighten monetary policy in order to reduce the money supply, which would slow down the economy and help fight inflation.
“To break the inflation cycle, we must have credible and disciplined monetary policy.” — Paul Volcker
Typically, the way the Fed tightens monetary policy is by increasing the interest rate at which it lends to banks (i.e. Fed fund rate). However, Volcker felt this approach was no longer appropriate. Instead, he proposed a way of managing the volume of bank reserves in the system instead of trying to manage the day-to-day level of the federal funds rate.
“By emphasizing the supply of reserves and constraining the growth of the money supply through the reserve mechanism, we think we can get firmer control over the growth in money supply in a shorter period of time. But the other side of the coin is in supplying the reserve in that manner, the daily rate in the market…is apt to fluctuate over a wider range than had been the practice in recent years.”
By focusing on controlling the reserves in order to control the country’s monetary supply, the federal funds rate reached a record high of 20% in late 1980 (compare this to the 0.25% Fed Funds rate today!). Why did the Fed funds rate increase so much?
It’s the law of supply and demand. If the supply of money that the Fed is allowed to lend is limited based on the supply of reserves in the bank, then any additional demand will cause prices to increase.
Since the Fed funds rate was so high, it pushed the economy into a severe recession. Businesses experienced liquidity problems, and unemployment rates continued to rise. Volcker was well aware of this risk and warned that such an outcome was possible:
“Some difficult adjustments may lie ahead.”
The general public was less than happy, to put it mildly. The high interest rates affected people who had been saving to buy homes and cars for many years. Suddenly, people were unable to fulfill these dreams because of high interest rates. Car dealers sent coffins full of the keys of unsold cars to the Fed’s headquarters. Farmers started protests. Things were getting ugly.
The Fed was blamed for supporting big businesses and instead of small businesses and farmers. Conservative Congressman George Hansen stated during a 1981 hearing that…
“We are destroying the small businessman. We are destroying Middle America. We are destroying the American dream”
Even President Reagan did not approve of Volcker’s new approach:
“What I am suggesting is that if (money supply growth) stays here, you’re going to have a severe recession”
Volcker defended the Fed’s actions in his 1981 testimony to the Senate Committee:
“I am wholly convinced — and I think I can speak for the whole Board and whole Open Market Committee — that recognizing that that objective for unemployment [4 percent] cannot be reached in the short run — the kinds of policies we are following offer the best prospect of returning the economy in time to a course where we can combine as full employment as we can get with price stability.I bring in price stability because we will not be successful, in my opinion, in pursuing a full employment policy unless we take care of the inflation side of the equation while we are doing it. I think that philosophy is actually embodied in the Humphrey-Hawkins Act itself. I don’t think that we have the choice in current circumstances — the old trade-off analysis — of buying full employment with a little more inflation.We found out that doesn’t work, and we are in an economic situation in which we can’t achieve either of those objectives immediately. We have to work toward both of them; we have to deal with inflation. And the Federal Reserve has particular responsibilities in that connection.”
Volcker felt that changing course now would only make matters worse, so he stuck to his original plan. It got to the point where various congressmen wanted Volcker impeached. Even with such threats, Volcker held his ground
And guess what? His strategy actually worked!
By July of 1982, the recession had bottomed out. Inflation began to decline, falling to 6.1% in early 1982 and then to 3.7% in the following year. The unemployment rate hit a peak of 10.8% in late 1982 before beginning a steady decline.
When Chairman Volcker left his post in 1987, the inflation rate was around 3–4%.
Following the Volcker disinflation, both output and inflation were much less volatile from the mid- 1980s through 2007 (primarily Chairman Greenspan’s term).
Once inflation was under control, there was so much improvement in the economy in the period that followed from the late 1980s to 2007, that this period became known as the “Great Moderation.”
“An environment of greater economic stability has been key to impressive growth in the standards of living and economic welfare so evident in the United States.” — Alan Greenspan
What caused the Great Moderation?
To this day, there is no consensus on what exactly caused the Great Moderation. People attribute it to a mix of factors, which we will briefly discuss next.
1) Structural changes in the economy
Some economists think that the reason for the steady period of economic growth was structural. A macroeconomic shift from a manufacturing-based economy (more volatile) to a services-based economy (less volatile) led to reduced volatility. Additionally, better business practices like “just-in-time” manufacturing could have helped reduce the volatility in the inventory cycle. And the rise of information technology allowed companies to produce goods more efficiently, which reduced volatility in production (and hence, in real GDP).
Another structural factor could have been that the deregulation of many industries allowed various economies to be more flexible and permitted them to adjust more smoothly to shocks. Lastly, more open international trade could have helped stabilize the economy.
2) Improved monetary policy after 1979
Before the Great Moderation, monetary policy often followed a “go-stop” policy. During the “go” phase, monetary policy was eased to fight recessions, and during the “stop” phase, monetary policy was tightened to fight high inflation. The Fed often kept monetary policy easy for too long, leading to high inflation. Then it would tighten policy for a brief time. This led to erratic changes in inflation during the 1960s and 1970s.
In the early 1990s, the Fed started following the Taylor Principle, named after economist John B. Taylor. Under this rule, the central bank tightens monetary policy when GDP is above its potential or inflation is high and eases policy in the opposite case. In effect, the Fed would constantly be monitoring the economy and making policy changes, instead of only making changes in an emergency.
Reducing the episodes of “go-stop” policies created a more systematic monetary policy, which could have been another factor that helped reduce volatility.
Another big structural change was the transparency the Fed now had in communicating its monetary policy. This helped them better anchor inflation expectations, and there was less chance for the public and financial markets to be surprised. Baking in the monetary policy led to less volatility (theoretically, at least).
Luck is another possible explanation. Perhaps it was just that the United States was hit by less severe shocks during this period, compared to the adverse shocks of the 1960s and 1970s (e.g., the oil shocks of the 1970s).
Financial stresses did occur (for example, the savings and loans crisis of the 1980s; the Latin American debt crisis of the 1980s; the failure of Continental Illinois Bank in 1984; the stock market crash of 1987; the Asian financial crisis in 1997; the collapse of Long-Term Capital Management in 1998; and the dot-com crash in 2000, all of which we will learn about in a future post), but they were not as severe. However, perhaps it was that these shocks were less severe due to the structural and policy changes we discussed above, which allowed the economy to remain stable? This remains a hotly debated topic.
In the next article, we will take a little tour through some of the “minor” shocks that happened throughout the 1980s and 1990s. I will leave it up to you, the reader, to figure out whether you believe the shocks were minor enough not to disrupt the economy… Or, whether you believe that the economy had become resilient enough to withstand shocks, regardless of their intensity, and not cause an economic meltdown!