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The Monetary Policy of the Federal Reserve: A History.

The Monetary Policy of the Federal Reserve: A History by Robert L. Hetzel, Cambridge University Press, 2008. 390 pp.

This book is part of the "studies in macroeconomics" series by Cambridge University Press, a collection of titles that are of interest to macroeconomists and economic historians. Author Robert Hetzel's contribution to the series is a review and analysis of the monetary policy of the U.S. Federal Reserve. Robert Hetzel is Senior Economist and Policy Advisor in the Research Department of The Federal Reserve Bank of Richmond. He holds a Ph.D. from the University of Chicago and was a student of leading monetarist and Nobel Prize winner Milton Friedman.

Dr. Hetzel's study of the U.S. central bank is scholarly and comprehensive although most of the book is concerned with the years after the 1951 Accord between the Federal Reserve and the U.S. Treasury. The Accord released the Federal Reserve from the obligation of pegging interest rates of Treasury securities. After the Accord until the end of the 1950s, the Fed, led by William McChesney Martin traded in Treasury bills only and followed what has been called a "lean against the wind" policy. Martin emerges as the real hero of the Federal Reserve monetary policy making in the decade of the 1950s in Hetzel's account. During these years, Chairman Martin was so serious about keeping the lid on inflation that he would direct the Fed to apply the monetary brakes during the early expansionary phase of the business cycle. To describe the role of the Fed during these years Martin liked to say his job entailed "taking away the punch bowl just when the party was getting good."

Martin's job was made easier by the fact that the United States emerged from World War II as the leading economy in the world. Indeed, the decade of the 1950s was a golden age for the U.S. economy. The economy grew during this time with only modest inflation. The growth record was marred only by three relatively mild recessions.

In the decade of the 1960s, however, the Kennedy-Johnson administration put a priority on closing the gap between actual and potential GDP. Paul Samuelson and Robert Solow argued that U.S. policymakers could trade a higher inflation rate for a lower unemployment rate. This set the stage for the tax cut of 1964. The U.S. economy's growth rate accelerated and the unemployment rate fell, but by the end of the 1960s, inflationary pressures began to build.

In the latter part of the Johnson administration most economists argued that a tax increase was necessary. But the price of a tax increase for Johnson was easy money. After Johnson signed the Tax Surcharge of 1968, monetary policy remained expansionary through that year while the inflation rate increased to five percent. In 1969 the Fed tightened monetary policy, but Martin testified before Congress that "a credibility gap has developed over our capacity and willingness to maintain restraint." According to Hetzel, Martin's concern with the "expectational" character of inflation presaged the Volcker-Greenspan years at the Fed.

In 1970, President Nixon appointed Arthur Bums to succeed Martin at the Fed. After several years of moderately tight fiscal and monetary policy Hebert Stein called "gradualism," the Nixon Administration adopted wage and price controls and the Federal Reserve moved toward an easy money policy. The eight Bums years and the very short period that followed under the leadership of G. William Miller is referred to as the years of "stop and go" monetary policy by Hetzel. During this period the Fed was not successful in stimulating the economy nor in bringing inflation under control. Robert Hetzel calls this period as the Fed's "lost decade." During this time, inflationary expectations lost their anchor.

Paul Volcker succeeded G. William Miller and Volcker emerges as the policymaking star of the late 1970s and early 1980s as the Volcker Fed brought inflation down using a resolute monetary policy that focused on the control of monetary aggregates. The Volcker policy succeeded but at a huge cost to the economy. Interest rates reached their highest level since the Civil War and a major recession ensued. When the recession ended in 1983, however, the U.S. economy expanded for many years with only moderate inflation.

Alan Greenspan, Mr. Volcker's successor successfully dealt with the stock market crash of 1987. The economy continued to expand until a short recession occurred in 1991. After the economy rebounded, the Greenspan Fed took preemptive action to stem inflation in its incipiency. For example, in the mid-1990s when inflation was quite moderate, the Federal Reserve raised the federal funds rate to take demand out of the economy in anticipation of building inflationary pressures. The Federal Reserve was criticized for this policy move but Alan Greenspan, like his predecessors Volcker and Martin according to Hetzel, attached a great deal of importance keeping the public's expectations of inflation stable. Stable price expectations and Federal Reserve credibility allowed the Fed to conduct an expansionary monetary policy in response to the Asian economic crisis that began in the summer of 1997.

Beginning in June 1999, the Fed gradually started to raise the funds rate. The economy continued to grow and equity markets soared until September 2000 when NASDAQ started a prolonged slide. The resulting fall in wealth reduced spending and economic activity peaked in March 2001. Shortly thereafter, the economy experienced the shock of the terrorist attack in September 2001, the corporate governance scandals of 2002 and the Iraq War of 2003.

Policymakers at the Fed moved aggressively in response to these events. The federal funds rate moved down from 6.5% in January 2001 to 1% in June 2003. The U.S. economy proved to be quite resilient; inflation remained moderate from 2004 to 2006. Some attribute the remarkable macroeconomic record through the Greenspan years to the surge in average labor productivity and what was then called the "new economy." Others argue that deft discretionary monetary policy also played a significant role. Hetzel, however, maintains that the remarkable economic performance during most of these years resulted from what he calls the use of an implicit "rule" by the Fed that established a nominal anchor in the form of a low, stable expected inflation rate. Hetzel believes that this allowed the price system to work most efficiently.

Hetzel's treatment of the impact low interest rates on the residential housing market during the Greenspan years is rather brief. The speculative bubble and the explosion of the bubble that followed, of course, contributed to the financial crisis and the great recession that started in December 2007. The author's historical analysis ends with the conclusion of the Greenspan term.

Robert Hetzel asserts that three lessons emerge from his history: (1) inflation is a monetary phenomenon whose behavior is determined by the central bank; (2) central bank credibility characterized by stability in expected inflation is of critical importance to inflation stability; (3) the central bank must allow the price system to work. Hetzel sees wage and price controls as a failure and as a distraction from the establishment of central bank credibility and stable inflationary expectations.

In his last chapter, Hetzel argues that the Federal Open Market Committee (FOMC), the monetary policy making group at the Fed, tamed inflation during the Volcker-Greenspan years by behaving consistently. It raised the federal funds rate in a regular and measured manner any time real output rose above trend in a sustained way. Hetzel asserts that the markets came to believe that the FOMC would move the federal funds rate by whatever amount required to maintain trend inflation unchanged during most of the post 1983 period.

Hetzel concludes that institutionalization of the Volcker-Greenspan regime would start with an inflation target. He believes that an explicit inflation target accompanied by an explicit strategy for achieving it would increase public understanding of monetary policy and build support for continued Federal Reserve independence.

While a number of central banks around the world have moved to inflation-targeting, such a proposal for a similar move by the Federal Reserve would be controversial. In 2006, during the confirmation hearings of Ben Bernanke, several influential U.S. senators stated that directing the Fed to target inflation would require a change in the Federal Reserve Act, the legislation that created the central bank and established its monetary policy objectives. Robert Hetzel himself admits that much has to happen to make inflation-targeting a reality for U.S. monetary policy.

The Monetary Policy of the Federal Reserve could be used in a course in American economic history. It would be most appealing for those who take a modern monetarist perspective. The book lists many scholarly sources and contains numerous figures illustrating points made in the text. It is attractively published and comes with a handsome blue and white dust jacket depicting the Great Seal of the United States that appears on the back side of our one dollar bill.


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Author:Perkins, William C.
Publication:American Economist
Date:Mar 22, 2011
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