A HIS T ORY OF T HE F E DE R A L R E SE RV E



a l l a n h. melt z er

a his t or y of t he

Federal Reserve
volu me ii, bo ok one, 1951–19 69

t he univ ersit y of chic ago press • chic ago and london


Allan H. Meltzer is the
Allan H. Meltzer University
Professor of Political Economy
at Carnegie Mellon University
and Visiting Scholar at
the American Enterprise
Institute. He is the author
of many books, including
A History of the Federal
Reserve: Volume I, also
published by the University
of Chicago Press.

The University of Chicago Press, Chicago 60637
The University of Chicago Press, Ltd., London
© 2009 by The University of Chicago

All rights reserved. Published 2009
Printed in the United States of America
18 17 16 15 14 13 12 11 10 09
isbn-13: 978-0-226-52001-8
isbn-10: 0-226-52001-3

1 2 3 4 5

(cloth)
(cloth)

Library of Congress Cataloging-in-Publicatin Data
Meltzer, Allan H.
A history of the Federal Reserve / Allan H. Meltzer
p. cm.
Includes bibliographical references and index.
Contents: v. 1. 1913–1951—
isbn 0-226-51999-6 (v. 1 : alk. paper)
1. Federal Reserve banks. 2. Board of Governors of
the Federal Reserve System (U.S.) I. Title
hg2563.m383 2003
332.1′1′0973—dc21
2002072007
The paper used in this publication meets the minimum requirements of the American National Standard
for Information Sciences—Permanence of Paper for
Printed Library Materials, ansi z39.48-1992.


To Christopher C. DeMuth, Marilyn Meltzer, and Anna J. Schwartz
For their support and encouragement

over the many years this history was in process.



con t en t s

Preface ix

1

Introduction
1

2

A New Beginning, 1951–60
41

3

The Early Keynesian Era: A Low-Inflation Interlude, 1961–65
267

4

The Great Inflation: Phase I
480
The reference list and the index appear in volume II, book two.




pr eface

The second, and last, volume of this history covers the years 1951 to 1986
in two parts. These include the time of the Federal Reserve’s second major mistake, the Great Inflation, and the subsequent disinflation. The volume summarizes the record of monetary policy during the inflation and
disinflation.
Early in the Fed’s history, and even in its prehistory, few doubted the
importance of separating the power to spend from the power to finance
spending by expanding money. The gold standard rule and the balanced
budget rule enforced the separation of government spending and monetary
policy. By 1951, both rules had lost adherents, especially among academics
and increasingly among policymakers and many congressmen.
The men who led the Federal Reserve during these years made many
speeches about the evil of inflation. They made mistakes and gave in to
political and market pressures for expansion. Many of their mistakes represented dominant academic thinking at the time. A minority view that
opposed the policies was heard from some outsiders and some reserve
bank presidents at meetings of the Federal Reserve, but most often it was
dismissed or disregarded. The role of the reserve bank presidents fully
justifies their continued presence on the open market committee. They
often bring new or different perspectives that are not entirely welcome but
valuable nonetheless.
The volume starts with the first major change in Federal Reserve policy
following agreement with the Treasury to permit a more independent
monetary policy. The volume ends following the second major change to
a policy of disinflation. It would be comforting to see these changes as
evidence that “truth will out.” It must be added that both changes followed


x


pr efac e

a shift in political support that facilitated the change. The change to an
independent policy did not survive the 2007–9 crisis.
The Federal Reserve is said to be an independent central bank. The
meaning of independence changed several times. In the years after World
War II, Congress and several administrations recognized the political implications of unemployment and later of inflation. As a result, the Federal
Reserve often found it difficult to follow an independent course. Mistaken
beliefs and lack of courage sustained inflationary actions.
A subject that I do not raise in the text deserves mention. One of the
outstanding achievements of the Federal Reserve in Washington and at the
regional banks is the high level of integrity and purposefulness of the principals and the staffs. More than ninety years passed without major scandal.
There are very few examples of leaked information. This fine record has
been abused rarely. Although I find many reasons to criticize decisions, I
praise the standards and integrity of the principals.
Volume 2 records some successes and achievements but many persistent errors. As in the earlier volume 1, I let the principals explain their reasoning. Much of the material uses the records of meetings of the Federal
Open Market Committee. The Federal Reserve refers to these records as
transcripts or memoranda of discussion. I refer to them as minutes. They
find officials explaining their decisions many times but also showing an
understanding of their mistakes and the reasons they continued.
It took six or seven years to complete this volume. To write a volume
with such enormous detail I needed much help. It would have taken much
longer without the support of the bright and energetic assistants who read
and summarized the minutes and provided assistance in collecting data
and searching archives. I thank the nine assistants who worked at different times on the volume for their often insightful contributions. Thanks
to Matt Kurn, Mark de Groh, Richard Lowery, Randolph Stempski, Jessie
Gabriel, Jonathan Lieber, Hillary Boller, Daniel Rosen, and Danielle Hale.
I regard their efforts as indispensable. They were supported and assisted
by the helpful library staff at the Board of Governors. Thanks are due especially to Susan Vincent and Kathy Tunis, who guided me and many assistants through the records, and thanks also to David Small, Debby Danker,
and Normand Bernard of the Board’s staff for their help and support.

To supplement the Board’s records, I read the papers and records at the
Federal Reserve Bank of New York. The reserve banks are not subject to
the Freedom of Information Act. I am grateful to President William McDonough and to the archivist Rosemary Lazenby and her successor Joseph
Komljenovich for making the records available and for their assistance and


pr efac e

xi

guidance through their extensive files. With the passage of time and the
changed positions of Washington and New York, meetings of the New York
directors became a less important source of information. The papers of the
presidents and correspondence remained valuable.
Presidential libraries were a more important source of material after
1951. No one can read these volumes without seeing the influence of politics and politicians. Papers of presidents, presidential assistants, and other
officials contain records of policy development and conflicts. I benefited
from the able assistance of archivists and librarians at the Millar Center at
the University of Virginia, the Missouri Historical Society for the papers
of William McChesney Martin, Jr., the Kennedy Library in Boston, the
Johnson Library in Austin, the Carter Library in Atlanta, the Ford Library
at the University of Michigan in Ann Arbor, and the National Archive II for
the Nixon papers and the Nixon Oval Office tape recordings.
To supplement the written records and documents, I interviewed several participants. All of the following graciously gave their time and interpretations. They were particularly helpful in describing the atmosphere
in which decisions were made or rejected. I am grateful to each of the
following: Steven Axilrod, Andrew Brimmer, Joseph Coyne, David Lindsey, Kenneth Guenther, Jerry L. Jordan, Sherman Maisel, William Miller,
James Pierce, Charles Schultze, George Shultz, and Paul Volcker.
Sherman Maisel permitted me to use the diary that he kept during his
years as governor. These were very helpful and, as instructed, they are now
deposited at the Board of Governors.

On a visit to the research department in May 2003, I discussed the
meaning of Federal Reserve independence with Governor Donald Kohn,
Athanasios Orphanides, and Edward Ettin. Their comments helped me to
understand how Board members and their staff regard this central concern
of any monetary authority.
Along the way, I had the good fortune to have several readers who commented on drafts of the main chapters, in some cases on all of them. I
am especially grateful to Marvin Goodfriend, David Lindsey, and Anna
Schwartz, who read and commented helpfully and extensively on all of the
historical chapters. Jerry Jordan, David Laidler, Athanasios Orphanides,
and Robert Rasche made insightful comments on several chapters. Responsibility for accepting comments and for remaining errors or misunderstandings are, of course, mine.
Much of the archival material is in Washington. Without my long association with the American Enterprise Institute and its support for me
and the many assistants named above, this work would not have been


xii

pr efac e

completed. I thank especially Chris DeMuth and David Gerson for their
support. I benefited also from the support of the Tepper School at Carnegie Mellon University.
Several foundations provided support. I am especially grateful to my
friend Richard M. Scaife for his many contributions and to the Sarah Scaife
Foundation. The Earhart Foundation, the Lynde and Harry Bradley Foundation, and the Smith Richardson Foundation also gave helpful assistance.
Thank you.
Alberta Ragan typed, proofread, and revised the manuscript several
times. Her cheerful, capable, and willing assistance made completion
much easier.
Finally, I owe much to my wife, Marilyn, whose support and encouragement were never in doubt and always present.



one

Introduction

Exact scientific reasoning will seldom bring us very far on the way to the conclusion for
which we are seeking, yet it would be foolish to not avail ourselves of its aid, so far as it will
reach:—just as foolish would be the opposite extreme of supposing that science alone can
do all the work, and that nothing will remain to be done by practical instinct and trained
common sense.
—Marshall, 1890, 779, quoted in Blinder, 1997, 18

The Federal Reserve that we find in these volumes is very different from
the institution founded in 1913. Carter Glass, one of its founders, always
insisted it was not a central bank. Its main business was the discounting
of commercial paper and acceptances governed by the real bills doctrine
and subject to the gold standard rule. The United States was an industrial
economy, but agriculture retained a significant role and furnished about
40 percent of exports. Discounting facilitated the seasonal increase in
loans that supported agricultural exports.
By the 1980s, when this volume ends, the United States had become
a postindustrial economy, by far the largest economy in the world. The
Federal Reserve was the world’s most influential central bank. No one had
denied it this title for at least fifty years. Much had changed. Discounting
became a minor function. The gold standard was gone. Principal central
banks issued fiat paper money and floated their exchange rates.
During its early years and for many years that followed, the Federal
Reserve System’s concerns included par collection of checks and System
membership. Many small banks earned income by charging for check collection. The payee received less than the face amount of the check. Members were required to collect at par. Many small, mainly country, banks



2

chap ter 1

did not join the System to avoid par collection and to avoid costly reserve
requirement ratios. Both problems ended by the 1980s when Congress
made all banks adopt Federal Reserve reserve requirement ratios even if
they declined membership.
The most significant change was increased responsibility for economic
stabilization, a mission that officials first denied having. Two economic
and political forces changed that belief. One was developments in economic theory beginning with the Keynesian revolution in the 1930s and
later the monetarist counterrevolution in the 1960s and the Great Inflation
of the 1970s.
The principal monetary and financial legacies of the Great Depression
were a highly regulated financial system and the Employment Act of 1946,
which evolved into a commitment by the government and the Federal Reserve to maintain economic conditions consistent with full employment.
The Employment Act was not explicit about full employment and even
less explicit about inflation. For much too long, the Federal Reserve and
the administration considered a 4 percent unemployment rate to be the
equilibrium rate. The Great Inflation changed that. By the late 1970s,
the targeted equilibrium unemployment rate rose and Congress gave more
attention to inflation control. The resolution was reinterpretation of the
Employment Act as “a dual mandate” to guide policy operations at the end
of the last century and beyond. The guide does not clearly specify how a
tradeoff between the two objectives—low inflation and a low unemployment rate—should be made when required. But it is now more widely
accepted that in the long run, employment and unemployment rates are
independent of monetary actions, so that monetary policy is fully reflected
in the inflation rate and the nominal exchange rate.
The founders of the Federal Reserve intended a passive but responsive
institution with limited powers. Semi-independent regional branches set

their own discount rates at which members could borrow. The borrowing
initiative remained with the members. Creation of the Federal Reserve
brought regional interest rates closer together. By the mid-1920s, the System became more active. Under the leadership of Benjamin Strong, it initiated action to induce banks to borrow or repay lending. From this modest
start, open market operations became the Federal Reserve’s principal and
usually only means of changing interest rates and bank reserves. Discounting almost disappeared; advances became a very small activity used mainly
for seasonal adjustment by agricultural lenders.1 Following passage of the
1. The Federal Reserve can also change reserve requirement ratios to add or reduce available reserves. If it keeps the interest rate unchanged, the only effect of the change is to raise


in t roduc t ion

3

Employment Act, the Federal Reserve at first recognized responsibility
mainly for employment and to a lesser extent for inflation. The weight on
inflation increased in 1979, a result of the Great Inflation.
Like most central banks, the Federal Reserve avoided taking risk onto its
balance sheet. Until 2008 both by statute and by its own regulations, it limited the assets it acquired principally to Treasury securities, mainly shortterm bills, and gold (or gold certificates after 1934) and foreign exchange.
Originally the Federal Reserve tried to develop a market in bankers’ acceptances, but it did not succeed. In 1977, it ceased open market operations
in bankers’ acceptances. Under pressure from Congress to assist housing
finance, it purchased small volumes of agency securities in the 1970s.2
Small and Clouse (2004, 36) reviewed the legal and regulatory rules
that apply to the Federal Reserve’s asset portfolio.
In usual circumstances, the Federal Reserve has considerable leeway to lend
to depository institutions, but a highly constrained ability to lend to individuals, partnerships, and corporations (IPCs). The lending to depository
institutions can be accomplished through advances (rather than discounts)
secured by a wide variety of private-sector debt instruments. In discounts for
depository institutions, the instruments discounted generally are limited to
those issued for “real bills” purposes—that is agricultural, industrial, or commercial purposes. The Federal Reserve can make loans to IPCs, but except in
unusual and exigent circumstances, the loans must be secured by U.S. Treasury securities or by securities issued or guaranteed by a federal agency.3


The evolution that changed an association of semi-independent reserve
banks into a powerful central bank reflects interaction between policy,
events, and monetary theory. Volume 1 showed the importance of the gold
standard and, even more, the real bills doctrine that had a powerful role
in sustaining the Great Depression. This volume documents the role of
Keynesian thinking in creating the Great Inflation and mainly monetarist
thinking in bringing inflation back to low levels.
Intervention between monetary theory, policy, and events is one part of
or lower the multiplier applied to reserves and the transfer of bank reserves to or from the
Federal Reserve.
2. In 2008, the Federal Reserve changed this policy. Abandoning all past precedents, it
lent on relatively illiquid long-term debt. Within a few weeks more than half of its portfolio’s
consisted of longer-term debt. This represented a break with all previous central bank experiences in developed countries.
3. Small and Clouse (2004, 29) point out that it is clear that the “real bills” limitation in
section 14 of the Federal Reserve Act applies to purchases of bills of exchange but unclear
whether it applies to bankers’ acceptances. The limitation does not apply to purchases of
foreign instruments.


4

chap ter 1

the story. Changing beliefs about the role of government is another. By the
middle of the twentieth century, citizens (voters) in all the developed countries accepted that government had a responsibility to maintain economic
prosperity. This raised a critical issue. Voters could punish an administration or Congress for actions of the Federal Reserve. Responsibility and
authority remained separate.
The next sections discuss three main themes of this volume. First is
the relation of monetary theory to monetary policy. Second is the meaning

of central bank independence. Third is inflation, the dominant monetary
event of the years 1965 to 1985.
The monetarist-Keynesian controversy had a large role in bringing
about changes in policy. Federal Reserve officials never agreed upon a theoretical framework for monetary policy, but the controversy and research
influenced them. In the 1980s, Chairman Volcker called his framework
“practical monetarism.” This was a major change from the approaches advocated by Chairmen Martin and Burns. Changing views about the meaning of central bank independence and its practical application contributed
to the start, persistence and end of the Great Inflation.
T H E K E Y N E SI A N E R A

In the early postwar years, policymakers assigned a major role in stabilization policy to fiscal actions. Monetary actions had a minor supporting role,
mainly to support fiscal generated expansions or contractions by avoiding
large changes in interest rates. Herbert Stein (1990, 50) listed the seven
assumptions used in the early postwar versions of Keynesian economics.
Stein described these assumptions as “the simple-minded Keynesianism
that a generation of economists learned in school and which became the
creed of modern intellectuals.”
1. That the price level was constant, so that demand could be expanded without danger of inflation.
2. That the potential output of the economy, or the level of full employment, was given—that it would not be affected by the government’s
policy to maintain full employment.
3. That we knew how much output was the potential output of the
economy and how much unemployment was full employment.
4. That the economy had a tendency to operate with output below its
potential and unemployment above its full employment level.
5. That output and employment could be brought up to their desirable levels by fiscal actions of government to expand demand—
specifically by spending enough or by running large deficits.


in t roduc t ion

5


6. That we knew how much spending or how big deficits would be
enough to achieve desired results.
7. That there was no other way to get to the desired levels of output
and employment, the main implication of which was that monetary
policy could not do it.
To economists in the twenty-first century, these assumptions and claims
seem extreme, simplistic, even simpleminded. Three citations suggest
how broadly it was held. First is the survey of monetary theory written for
the American Economic Association’s sponsored Survey of Contemporary
Economics (Villard, 1948). Second is the 1959 report of the Radcliffe Committee in Britain, written after inflation had become a problem in Britain, the United States, and elsewhere (Committee on the Working of the
Monetary System, 1959). Third is the American Economic Association’s
Readings in Business Cycles (Gordon and Klein, 1965). I cite these studies
not because they were unusual but because they reflect the dominant or
consensus views found in professional discussion, in popular textbooks
such as Ackley (1961), and in econometric models of the period.4
Simple Keynesian ideas dominated the analysis in Employment, Growth,
and Price Levels prepared by professional economists for Congress in
1959(Joint Economic Committee 1959a). The report denied long-run monetary neutrality, gave no attention to expected inflation, and argued that the
economy could not on its own achieve full employment and price stability
without guideposts for wages and prices. Chairman William McChesney
Martin, Jr., did not share this view, and the Federal Reserve’s statement to
Congress did not endorse it.
The Federal Reserve opposed securities auctions and helped to finance
budget deficits, a main source of inflationary money growth after 1965.
Treasury later began auctions. In time, the Federal Reserve ended “even
keel” operations used to reduce interest rate changes during Treasury
financings.
The early Keynesian model evolved. By the 1960s a Phillips curve relating some measure of inflation to output, the gap between actual and full
employment, or unemployment became a standard feature. Prices no longer remained constant; aggregate demand could exceed full employment

output, resulting in inflation.
What remained unchanged was the belief that money growth had at
most the secondary role of financing deficits or fiscal changes to prevent
interest rates from rising, or from rising “unduly.” Policy coordination
4. This paragraph repeats Meltzer (1998, 9).


6

chap ter 1

became an accepted policy program in the 1960s. In practice, coordination meant that monetary expansion financed government spending or
tax reduction and also moderated the negative effects on employment of
anti-inflation fiscal actions.
There is often not a close connection between academic research findings
and recommendations and Federal Reserve actions. This was certainly true
of the 1950s. Chairman Martin had little interest in economic theory or its
application. His principal advisers, Winfield Riefler and Woodlief Thomas,
revived a modified version of the 1920s policy operations that gave main
attention to the short-term interest rate and credit market conditions. To
mask its role in affecting interest rates, the Federal Reserve most often set
a target for free reserves—member bank excess reserves net of borrowed
reserves. Free reserves moved randomly around short-term interest rates.
Keynesian influence became much more visible in the 1960s. President Kennedy brought leading Keynesian economists into the administration. They continued the regular meetings, started in the Eisenhower administration, that brought the Federal Reserve chairman together with the
president and his principal economic advisers. These meetings and other
contacts sought to increase policy coordination and reduce Federal Reserve
independence. And Presidents Kennedy and Johnson chose members of
the Board of Governors who shared mainstream Keynesian views. As older
staff retired, the Federal Reserve staff and advisers acquired younger economists trained in Keynesian analysis. By the late 1960s, the Keynesian
approach dominated discussion.

Similar changes affected Congress. Avoiding recession became the priority. Hearings reflected the urgency felt by many to avoid an unemployment rate above 4 percent, considered full employment.
Chairman Martin at the Federal Reserve did not share these interpretations. He had a restricted view of both Federal Reserve independence and
the power of monetary policy. To him, the Federal Reserve was independent within the government. This meant that Congress voted the budget.
If they approved deficit finance, the Federal Reserve’s obligation called for
monetary expansion to keep interest rates from rising. Martin blamed the
deficit for inflation. As he said many times, he did not understand money
growth. Thus, he permitted inflation to rise despite his many speeches
opposing the rise. Although he did not share the Keynesian analysis, he
enabled their policies.
Federal Reserve policy relied on interest rate ceilings (regulation Q)
to control credit expansion. Substitutes for bank credit developed to circumvent regulation. The euro-dollar market enabled banks to service their
customers and money market mutual funds substituted for time depos-


in t roduc t ion

7

its. Governor James L. Robertson especially recognized that the System
should end reliance on rate ceilings, but the timing never seemed right.
Opposition in Congress contributed to the lack of action. Also, the Federal
Reserve did not distinguish between real and nominal rates, a problem
after inflation rose. Brunner and Meltzer (1964) formalized the Federal
Reserve’s analysis.
T H E MON E TA R IST C R I T IQU E

Clark Warburton was an early critic of Keynesian analysis.5 Warburton
concluded from his empirical work that erratic changes in money growth
were the main impulse producing recessions. Real factors had a secondary
role. In the long run, money was neutral.

One of the earliest propositions of monetary economics, expressed in
the quantity theory, claimed that the monetary authority determined the
stock of money, but the public determined the price level at which the stock
was held. In a modern economy with developed asset markets, an excess
supply of money increases the demand for existing assets in addition to or
in place of increases in commodity demand. Higher asset prices induce
increased demand for investment.
Beginning in the mid-1950s, Milton Friedman and his students and
collaborators produced theoretical and empirical analyses of the role of
money. In Studies in the Quantity Theory of Money (1956), Friedman challenged the Keynesian view that money substituted only for bonds or, in
practice, Treasury bills. In the most developed Keynesian models, wealth
owners optimized their portfolio of bonds and real capital, then separately
distributed short-term holdings between money and Treasury bills (Tobin,
1956 and elsewhere). Friedman treated money as part of an intertemporal portfolio; money holding substituted for bonds, real capital, and other
stores of wealth as in classical analysis. The effect of changes in the stock
of money were not limited to the interest rate on Treasury bills. Relative
prices on domestic assets and the exchange rate or foreign position responded to the change in money.6 In their Monetary History, Friedman and
Schwartz (1963) showed that money growth had a major role in fluctuations, inflation and deflation.
5. Michael Bordo and Anna J. Schwartz (1979) review Warburton’s work. This section is
based on Brunner and Meltzer (1993, chapter 1).
6. This difference remains as demonstrated in discussions of a liquidity trap in the
1990s. Keynesian thinking emphasizes difficulties for monetary policy caused by a zero
bound on nominal Treasury bill rates. A monetarist (non-Keynesian) responded that a central bank could buy other assets, longer-term securities, foreign exchange, or even equities.
Brunner and Meltzer (1968).


8

chap ter 1


Discussion and controversy went through several phases. Among the
central issues were the properties of the demand for money, the distinction between real and nominal interest rates, real and nominal exchange
rates, and between the short- and long-run Phillips curves.7 By the late
1970s, economists reached a consensus on many of the disputed issues.
In his presidential address to the American Economic Association, Franco
Modigliani, a leading Keynesian economist, acknowledged that the monetarist position was correct on these issues (Modigliani, 1977). The principal remaining issue between monetarists and Keynesians that he did
not concede was whether monetary policy should follow a rule or proceed
according to the discretionary choice of officials. Issues no longer in dispute included the long-run neutrality of money, the effects of inflation on
money wages, nominal interest rates, and exchange rates, and any permanent real effects of inflation. Four fundamental issues affecting monetary
policy remained: the role of monetary rules, the definition of inflation, importance of relative prices in the transmission of monetary policy, and the
internal dynamics of a market economy, particularly whether it is mainly
self-adjusting.

Rules
Classical monetary policy was based on rules. The best-known rule was
the gold standard, but other proposed rules included bimetallism, commodity standards, and real bills. The aim was to achieve price or exchange
rate stability. Keynesian analysis shifted the emphasis from rules to discretionary actions by governments and central bankers. Monetary policy,
at first, had the modest role of financing fiscal actions, as discussed above.
Its responsibilities increased until it held a prominent role in stabilizing
the economy. Discretionary actions intended to stabilize were based on
judgments of current and possibly longer-term consequences of events
and policy actions.
Early in the discussion of rules and discretion Friedman (1951) recognized the importance of information and uncertainty in choosing between
a rule and discretionary actions. A well-intentioned policymaker may destabilize if he is misled by incomplete or incorrect information. Later
work by Kydland and Prescott (1977) and a large literature that followed
analyzed time inconsistency and the credibility of policy actions and announcements. Kydland and Prescott showed that the dynamic path that
7 Meltzer (1998) has a more complete discussion of the result of the controversy. Modigliani (1977) is a useful statement from a Keynesian perspective of the consensus reached
at the end of the 1970s.



in t roduc t ion

9

the economy follows depends on the choice of policy rules. A discretionary
policy that made an optimal choice today was time inconsistent if it did
not follow a rule restricting future actions. An individual or firm planning its future actions experienced increased uncertainty when faced by
discretionary policy.
A major change in economic theory came with recognition of uncertainty and the role of information. This heightened attention to the role
of expectations. Lucas (1972) developed earlier work on rational expectations.8 Rational expectations raised a question about the meaning of discretion. In practice, many central banks responded by providing more and
better information about current and future actions. Rational expectations
implies that central banks depend on market responses and markets depend on central bank actions. Setting and achieving a target for inflation
two or three years ahead is a recognized way of reducing uncertainty about
future actions. Federal Reserve officials have not adopted a formal inflation target, but, for a time, they encouraged a belief that they try to hold
inflation in the 1 to 2 percent range, and in 2007 they began to forecast
inflation, output, and unemployment for three years ahead. In early 2008,
however, they gave most weight to forecasts of possible recession and less
weight to inflation.
These actions constitute a major change from the secrecy traditionally
practiced by central banks. It recognized the developments in monetary
theory about the role of information, the importance of anticipations, and
the success achieved by foreign central banks that announced inflation
targets. But United States governments have not adopted fixed rules and
are unlikely to do so in the foreseeable future.
Central bankers continue to meet regularly to decide current actions.
Prominent central bankers have explained why they do not commit to a
fixed rule. The former chairman of the Federal Reserve, Alan Greenspan
(2003), explained that a fixed rule could not take account of the many
contingencies to which monetary officials might wish to respond. The contingencies are infinite and most are unforeseeable. Many of the contingencies arise from actual or potential financial failures. The monetary rules
developed in the literature do not incorporate these contingencies. In the

past, following Bagehot (1873 [1962]) the central bank or the government
announced in advance that it would suspend the gold standard rule at such
times and provide the increased reserves demanded. This became part of
the monetary rule.
8. Brunner and Meltzer (1993) point out that rational expectations models usually assign
considerable weight to information but zero weight to the cost of acquiring information.


10

chap ter 1

Greenspan’s successor, Ben Bernanke (2004), recognized that the central bank can do a great deal to reduce uncertainty about its future actions,
but “specifying a complete policy rule is infeasible” (ibid., 8). He accepted
Greenspan’s reason for infeasibility. Mervyn King (2004), governor of the
Bank of England, called for “constrained discretion.” “Suitably designed,
monetary institutions can help to reduce the inefficiencies resulting from
the time-consistency problem” (promising one thing but later doing another) (ibid., 1). Otmar Issing, former chief economist and board member
of the European Central Bank, expressed a similar position on many occasions (Issing, 2003, for example). He regarded as impossible in practice
the idea of following a fixed rule.
The chapters that follow show that the Federal Reserve changed its objectives and its target many times. Often it did not have a precise target. Even
after Congress required the Federal Reserve to announce an annual monetary target, it did not adopt procedures to achieve the target and allowed excess money growth to remain by following the practice called “base drift.”
Table 1.1 from the 1980s shows the changing objectives pursued during
1985–88. The principal objective changed frequently, making it difficult
for the public to plan. The Federal Open Market Committee (FOMC) did
not announce the objectives at the time, and the statement of objectives
was sufficiently vague that knowing the objectives would not help observers to anticipate policy actions. And because it chose four or five objectives,
the public could only guess the relative importance of each or its influence
on Federal Reserve actions.
By the 1990s, principal central banks followed King’s “constrained discretion.” Many used some version of Taylor’s (1993) rule as a guide, but they

deviated when they chose to do so. Several adopted inflation targets and
gave more information about proposed actions and objectives. None followed a precise rule.

Definition of Inflation
Economists use two definitions of inflation, and laymen use some others.
Monetarists define inflation as a sustained rate of change in some broad,
general price index. The more common definition includes all price increases. Popular usage includes some relative price increases such as wage,
asset price, or energy price increases; an example is “wage inflation.”
Economic theory does not prescribe the choice of a stable price level
over a stable sustained rate of price change. The former requires central
bank policy to roll back or push up the price level following an event that


in t roduc t ion
Table 1.1

11

Order in Which Policy Variables Appeared in the FOMC Directive

meeting

first

second

third

fourth


3/85 to 7/85

7/87

Inflation

Credit Market Exchange
Conditions
Rates
Inflation
Credit Market
Conditions
Exchange
——
Rates
Inflation
Credit Market
Conditions
Inflation
Credit Market
Conditions
Strength of
——
Expansion
——
——

8/87 to 9/87

Inflation


11/87

Financial
Market
Conditions
Financial
Market
Conditions
Monetary
Aggregate
Inflation

Strength of
expansion
Strength of
Expansion
Strength of
Expansion
Strength of
Expansion
Monetary
Aggregate
Exchange
Rates
Monetary
Aggregate
Strength of
Expansion
Strength of

Expansion

Inflation

5/87

Monetary
Aggregate
Monetary
Aggregate
Monetary
Aggregate
Monetary
Aggregate
Exchange
Rates
Inflation

Strength of
Expansion
Strength of
Expansion
Strength of
Expansion

8/85 to 4/86
5/86
7/86 to 2/87
3/87


12/87 to
5/88
7/88
8/88 to
11/88

Exchange
Rates
Financial Market Conditions
Exchange
Rates
Strength of
Expansion
Monetary
Aggregate
Strength of
Expansion
Exchange
Rates
Inflation

fifth

Monetary
Aggregate
Exchange
Rates

——


Inflation

Exchange
Rates

Monetary
Aggregate

Inflation

Financial
Markets
Exchange
Rates

Exchange
Rates
Financial
Markets

Monetary
Aggregate

Monetary
Aggregate

Source: Economic Review, Federal Reserve Bank of San Francisco, Spring 1989, p. 11.

raises or lowers it. If this is successfully carried out, the public can expect
an unchanged price level over time. It incurs a cost because price adjustment is costly, particularly if the price level increased following a large

increase in the price of oil or in an excise tax on a subset of goods.
The monetarist position lets the price level become a random walk.
Energy price, excise tax increases, currency depreciation, or reductions
in productivity raise the price level; opposite movements reduce the price
level. These changes up and down often are spread through time. They appear as changes in the rate of price change, but they are not sustained.
Sustained money growth in excess of output growth induces a sustained
increase in the rate of price change. Milton Friedman’s often quoted statement that inflation is always a monetary phenomenon used the monetarist
definition of inflation. It recognized implicitly that non-monetary price
level changes are mainly relative price changes.


12

chap ter 1

A central bank must choose whether to control the price level or the
rate of price change. Each has different costs to society. Controlling the
sustained rate of price change permits the price level to vary, probably
as a random walk. Wealth owners have to accept price variability but can
be more confident when planning lifetime asset allocation that inflation
will be controlled. Controlling all changes in the rate of price change also
incurs a cost. The monetary authority must force other prices to decline if
oil (or other) prices rise and permit other prices to rise in the opposite case.
Such changes induce allocative changes and temporary changes in output
and employment. Experience under the classical gold standard suggests
that these costs are not small.
In practice, some central banks ignore some transitory changes in the
price level. The Federal Reserve targets the so-called core deflator for private consumption expenditures. This excludes changes in the prices of
food and energy on grounds that these prices are volatile and that many of
the changes are transitory. The public experiences the effects of food and

energy prices and considers these changes as inflationary. In 2007 the
Federal Reserve accepted responsibility for controlling these prices over
the longer term.
The use of a core price index is an inexact way of separating transitory
from persistent price level changes to get a better measure of sustained inflation. A superior alternative would use statistical estimation of the relative
variance of the permanent and transitory components to estimate whether
a given change is likely to persist. Muth (1960) suggested a procedure.
Persistent price changes—inflations—occur if sustained money growth
rises in excess of sustained output growth. The inflation rate changes,
therefore, if money growth rises relative to output growth or if normal output growth changes relative to money growth. The latter change occurred
in the mid-1990s in the United States. It produced a fall in the sustained
rate of inflation.
Implementing a monetarist policy to control inflation requires commitment to the low or zero inflation rule. Implementation of the policy
requires judgment about the permanent rates of change of money and
output. Many central banks now use an inflation target that they try to meet
over two or more years.

The Role of Relative Prices
The simple Keynesian model of the 1940 and 1950s had a single interest
rate representing the bond market or, in practice, the Treasury bill or federal funds rate. In the IS-LM model of that period, money was a substitute