Monetary policy - History
Monetary policy - Development over time
Monetary policy has developed considerably over time. It has also increased considerably in importance, and the actions of the Federal Open Market Committee (FOMC) has made it more public and prominent than ever before.
1913 to the 1940s
In the years after its foundation in 1913, the newly formed Fed focused on seasonal fluctuations in interest rates by issuing currency. Beyond this, little action was taken to track data about monetary aggregates or their relation to economic growth. For much of the time, the activity of banks was most often indirectly controlled through "moral suasion". A governor or senior official of the Fed would approach a banker and politely suggest that perhaps the banker would like to consider some changes in the way his/her bank was being operated. Few bankers looked forward to such contacts and fewer still were interested in resisting such suggestions. After the start of the Great Depression of 1929, economists began to recognize the existence of links between monetary contraction and bank failures. At the same time the Federal Reserve began collecting and using data on various monetary aggregates as an additional way to influence banks and monetary policy.
1950s to 1960s
The culmination of the effort to understand the role of monetary aggregates in an economy was Milton Friedman's A Program for Monetary Stability (1960) and, in 1963, the publication of the major study by Friedman and Anna Schwartz, A Monetary History of the United States, 1867 - 1960. The authors effectively argued that the Federal Reserve helped bring about the Great Depression by failing to stabilize the money supply. The challenge had now become using these theories in carrying out monetary policy.
1970s to 1980s
In the 1970s, increased attention was paid to monetary policy. Partly this wasbecause of the collapse of the fixed exchange rate regime (established by the Bretton Woods conference in 1944) in 1971, and the increased use of floating exchange rates by many central banks. However, perhaps even more importantly, in the early 1970s, inflation began to rear its ugly head. Oil price rises, wage disputes, and the residual effects of the "both guns and butter" economic policies followed during the Viet Nam War all combined to push inflation into realms previously unseen. The culmination was the 18% inflation rates that occurred during the Carter presidency (1977 - 1981). The Federal Reserve Chairman Paul Volker (1979 - 1987) wrung stagflation out of the US economy by concentrating on controlling the money supply rather than focusing on control of interest rates. The price was the recession of 1981 to 1982. The apparent reward was low inflation and economic growth during the rest of the Reagan presidency (1981 - 1989).
1990s to present
Despite the success of the monetary approaches utilized in the late 1970s and 1980s, the increase in new types of bank accounts and other financial services contributed to a breakdown in the ability to use M1 and M2 data to predict monetary growth. The Fed was not able to use monetary data to reliably predict growth in the money supply. This led the Federal Open Market Committee (FOMC) to discontinue setting target ranges for monetary growth. Under Chairman Alan Greenspan (1987 - 2006) inflation considerations were included in the policy choices made by the FOMC. However Greenspan rejected explicit inflation targets. He argued they would limit the policy responses available to the Fed when confronting recessionary forces. However the new Chair, Ben Bernanke has been an advocate of the use of formal inflation targets.
The use of monetary policy by the Federal Reserve continues to evolve. In March 1996, the Federal Reserve quit gathering data on M3 because collection was difficult and expensive, and only minimal linkage to growth in the money supply had been shown. Instead Fed economists have experimented with various redefinitions of the existing aggregates including the collection of data on a new aggregate, MZM. MZM excludes time deposits and only uses monetary data from M1, M2, and M3 that has zero limitations on access by time. The overall effort continues to be identifying linkages between monetary data, monetary policy, and changes in the economy.
An interesting contrast can be made to the Central Bank of the United Kingdom. During much the same period, the Central Bank of the UK focused its attention on M0 and M4. M0 is currency in circulation and immediately liquid deposits at the Central Bank. M4 is currency in circulation and sterling deposits at banks and building societies (building societies are similar to savings and loans in the US). In 1990 the UK joined the European Exchange Rate Mechanism (ERM). Additional official attention was paid to changes in exchange rates between the countries of Europe and the UK. Later in the 1990s the Government and the Central Bank began to set official, targeted limitations on the range of inflation, leading to greater formal attention on the role of inflation in the UK economy.
For a review by Ben S. Bernanke of the use of monetary policy at the Federal Reserve, see www.federalreserve.gov/newsevents/speech/Bernanke20061110a.htm.
For information on the Central Bank of the United Kingdom, see www.bankofengland.co.uk/.
