The monetary policy supremacy

The conduct of the US monetary policy

The Federal Reserve System was founded in 1913, just when the Gold Standard was coming to an end and World War I was about to break out. It was created as a lender of last resort. It was also supposed to supply as much money as was necessary, but there was no agreement on the best way to do it.

How quickly should it react to economic change? How much money should be supplied? In other words, the central bank was created, but an appropriate way to conduct monetary policy was still to be conceived. In this sense, the Fed was a sort of laboratory.

During the war periods, the primary objective of monetary policy was to minimize the borrowing costs of the Treasury. Throughout the interwar period, however, the Fed was unable to find an effective policy rule for conducting monetary policy. According to Taylor (1999), this “is evidenced by the disastrous economic performance during the Great Depression when money growth fell dramatically.”

In the recession of the early 1960s, short-term interest rates were kept relatively high in the United States – in order to attract short-term foreign capital (operation twist; Chapter 6) – and recovery was slow. In the late 1960s and 1970s, interest rates were kept low, responding too little and too late to changes in inflation and real output.

The policies of the Federal Reserve, which was reluctant to put a halt to growth, probably fueled the Great Inflation of that period, and the painful Volcker's disinflation that followed in 1979–1982 was the natural consequence.

After the conquest of American inflation, having left behind emergencies and this “training” age, the time came to resume the search for a proper way to conduct monetary policy.

The need to rethink monetary policy in a more systematic manner was clear to many economists, as noted by James Tobin: “I hope that history will give Paul [Volcker] and his colleagues the praise that they deserve not only for fighting the war against inflation but also for knowing when to stop, when to declare victory” (see Tobin, 1994).

Once the Great Inflation was vanquished, and with a recession in mid 1981, the Federal Reserve began to ease monetary policy in July 1982 up to December 1982.