A History of the Federal Reserve, Volume 2 (6 page)

Furlong and Kwan (2007) and Benston (2007) discuss several of the proposed changes in the United States. Congress approved several of the recommendations in modified form. It has not required banks to use subordinated debentures to shift risk from depositors or deposit insurance to investors (Calomiris, 2002). Agreeing on measures of financial risk proved difficult. Efforts to agree on international standards, the Basel accords, have proved unsatisfactory. A main reason is that the regulators failed to rely on incentives and diversification to enforce discipline. They chose regulation instead (ibid., 22–23). The accords encouraged banks to limit reserves by putting risky assets off their balance sheets. In 2007, these hidden risks became visible.

INTERNATIONAL

A central bank can direct its efforts at stability of either domestic or international prices. It cannot do both unless other central banks and governments agree on an exchange rate system. The Bretton Woods Agreement was such an agreement. The United States agreed to maintain the dollar at $35 per fine ounce of gold. Most countries agreed to maintain exchange rates fixed to the dollar or gold. Countries agreed to buy or sell dollars to maintain their fixed exchange rate. To correct a recognized weakness in the gold standard, countries could devalue or revalue to adjust to permanent changes in their equilibrium exchange rate. The agreement did not define permanent changes.

As the center of the system, the United States supplied dollars. The Bretton Woods period, 1945–1971, saw recovery in Europe and Japan. At first, most currencies remained inconvertible. By 1958 Western Europe agreed to convertibility on current account, and West Germany made the mark fully convertible. The United States began to experience balance of payments deficits. Payments for military assistance, defense, foreign aid, investment in Europe, and imports of consumer goods exceeded revenues.

The president and other officials repeatedly pledged their commitment to the $35 gold price. Whenever a problem arose during the Kennedy and Johnson administrations, they took administrative action—usually controls—to reduce the payments imbalances. Until 1968, the Treasury paid gold in exchange for dollars.

The Federal Reserve had a secondary role. Exchange rate and balance of payments remained a Treasury responsibility. The Banking Act of 1933 reduced the role taken by the New York Federal Reserve Bank in the 1920s. The Federal Reserve chose domestic policy, especially high employment, over international policy. To avoid painful increases in the unemployment rate, it did not persist in efforts at disinflation when unem
ployment rose. In 1971, President Nixon ended convertibility of the dollar into gold.

Attempts to restore a fixed exchange rate system after 1971 failed. By the mid-1970s, countries agreed to permit exchange rates to fluctuate. Principal European countries preferred fixed exchange rates, so they moved toward, and later adopted, a single currency.

Critics of floating exchange rates found many reasons to complain. Different effects of oil price increases, different rates of inflation, and changes in relative productivity growth produced large changes in exchange rates. Intervention to limit or prevent these changes added to the initial problems. Critics did not show that fixed exchange rates would be a better solution. Floating continued and remains.

A remarkable feature of policy under the Bretton Woods system was the inability or unwillingness to solve the basic problem—overvaluation of the dollar. Policymakers spent considerable effort developing a substitute for gold, the special drawing right (SDR). It had little importance. They did nothing to correct the more serious—and more obvious—problem, the overvalued dollar. Unilateral action by the United States forced attention to the so-called adjustment problem.

With some exceptions, the United States allows the dollar to float freely. The Federal Reserve sterilizes intervention. From 1985 to 1987, Treasury Secretary Baker first undertook to depreciate the exchange rate by agreement with other countries and then agreed to stabilize exchange rates. Like many political decisions, this one did not distinguish between real and nominal exchange rates. The agreement ended following the large worldwide decline in stock prices in October 1987.

RESEARCH

Improved research is one of the Federal Reserve’s significant achievements. From the 1920s on, the System encouraged research on monetary theory, banking, and aggregate economics. At first, researchers concentrated on developing data series useful for judging the current position of the financial and economic system. Research expanded in the postwar years at the Board and the reserve banks. Research at Richmond and St. Louis was helpful in changing policy by pointing out deficiencies in accepted ideas and proposing alternatives. Minneapolis has been a leading developer and advocate of rational expectations models.

The Board’s research staff took a leading role in developing large, econometric models of the economy. This effort focused staff attention on details of particular sectors. Policymakers have not found the forecasts from these models useful and have usually not followed them.

SUMMARY OF THE VOLUME

In the years 1951 to 1986 discussed in this volume, the world economy experienced a long period of sustained growth affecting more people in more countries than in any previous period. In the United States real per capita consumption more than doubled, more than an annual 2 percent compound average rate of increase. Although six recessions temporarily broke the economy’s growth, by the end of the 1970s inflation had become the major economic problem. At its peak rate of increase, consumer prices rose 12.5 percent in 1980 or 12.2 percent excluding one-time changes in food and energy prices (Council of Economic Advisers, 1989, 373). For the period as a whole, consumer prices doubled and redoubled, more than a 4 percent average annual rate of increase.

Inflation was not at all uniform. It remained low until 1966, then rose with the financing of the Vietnam War and the Great Society. Inflation fell after 1984 and remained moderate in the late 1980s and beyond. Chart 1.1 shows these data. The Federal Reserve later chose to monitor the deflator for personal consume
r expenditures excluding energy and food prices. In the short term this index differs from the consumer price index (CPI) mainly because weights on particular components differ in the two measures. Housing, medical care, and energy prices have been principal sources of short-term differences. Over a longer term, most broad-based
price indexes move together. Many short-term differences result from large relative price changes, not from sustained inflation.

Some economists attribute the Great Inflation to the end of price and wage controls or to the energy price increase. These changes affected the price level, temporarily raising the rate of price change. Persistent inflation shown in the chart, like all sustained inflation, resulted from excessive money growth.

Productivity growth is a noisy series (chart 1.2). It is not possible to know promptly whether changes are transitory or likely to persist. Economists have not agreed on the reasons for the decline in productivity growth in the 1970s despite substantial research effort.

Sustained changes in productivity growth are a main source of changes in expected output growth. Federal Reserve staff and many private sector economists use the difference between actual and expected output growth to forecast inflation. As Orphanides (2003a,b) showed, this was a main source of error in inflation forecasts in the 1970s. Meyer (2004) explained that it misled Federal Reserve economists who based inflation forecasts on the Phillips curve. Alan Greenspan did not rely on that model; his forecasts were more accurate in the 1990s.

Chart 1.3 shows that output growth is highly variable. Some research shows that the series is closely approximated as a random walk—that is, a series dominated in the short term by its random component. This is a main reason that quarterly forecasts using econometric models lack accuracy.

Currency depreciation follows domestic inflation unless foreigners inflate even more. Until August 1971, the United States kept the nominal exchange rate fixed at $35 per ounce of gold. Most other countries fixed their exchange rates in relation to the dollar and gold. To maintain the $35 dollar gold price, the Federal Reserve would have had to choose exchange rate stability over the requirements of domestic policy. The standard interpretation of the Employment Act of 1946 at the time gave most importance to maintaining full employment. Until the late 1970s full employment was considered a 4 percent unemployment rate. When the signals from the foreign exchange market and the unemployment rate diverged, the Federal Reserve followed the unemployment rate.

The real exchange rate adjusts the nominal rate for differences in price levels at home and abroad. From 1951 through 1980 the real exchange rate declined persistently. In the early 1980s the United States ended high inflation. Chart 1.4 shows that from the mid-1970s on the real and nominal exchange rates moved together. Nominal exchange rate changes are the dominant short-term influence on real exchange rate changes.

Between 1951 and 1986
, the annual average civilian unemployment rate varied between a low of 2.9 percent
in 1956 and a peak of 9.7 percent in 1982.
As Chart 1.5 shows, the unemployment rate rose quickly during
recessions as employers laid-off workers and reduced hiring. It declined slowly as the economy recovered. Local troughs in 1954, 1958, 1961, 1971, 1975, and 1982 show the effects of recession.

The Phillips curve posits a short-run negative relation between the unemployment rate and the inflation rate. The data suggest that the mediumor longer-term relation was positive in the 1970s and 1980s. On average the unemployment rate rose with inflation in the 1970s and both declined after 1982.

The chapters that follow use the real and nominal growth of the monetary base as indicators of the thrust of monetary policy. The uses of the monetary base consist of bank reserves and currency issued by the Federal Reserve. A common criticism points out that the uses of the base include mainly currency, much of it held abroad.

This criticism is mistaken. Sources of growth of the monetary base reflect mainly purchases of government securities by the Federal Reserve— injections of additional money or withdrawals. Currency held abroad is much more important for the level of the base and less important for interpreting the growth rate.

Chart 1.6 shows the growth rate of the monetary base. Inflation followed sustained increases. Charts in the following chapters show that recessions followed sustained declines in growth of the real base. The ch
arts compare growth of the real base to the expected real rate of interest. Volume 1 showed that declining real base growth preceded every recession and that when signals from real base growth and real interest differed, the economy
followed real base growth. The chapters that follow replace actual with expected inflation and reach the same conclusion