Marvin Goodfriend Federal Reserve Bank of Richmond Richmond, Virginia Marvin Goodfriend is senior vice president and policy advisor at the Federal Reserve Bank of Richmond. In this capacity, he serves as the principal monetary policy advisor to the Richmond Fed president, which includes accompanying him to Federal Open Market Committee meetings. Mr. Goodfriend has published widely on macroeconomics and monetary policy in professional journals. He serves on the advisory board of the Journal of Monetary Economics, the advisory committee of the Carnegie-Rochester Conference Series on Public Policy, and as an associate editor of the Journal of Money, Credit, and Banking.

The Federal Reserve was established in 1914 to manage the nation’s monetary policy. The country subsequently abandoned the strict rules of the gold standard for the freedom of a paper money standard. The history of inflation, employment, and interest rates has been a tumultuous one since then, in part because the paper standard proved surprisingly difficult to understand and manage. This article tells how the Fed slowly and painfully learned to make monetary policy in the absence of a link to gold.

The Gold Standard and the Early Fed
When the Fed was established, inflation was not the problem it became later in the middle of the 20th century. The United States was on the gold standard, and the purchasing power of money in 1914 was about what it had been 30 years before — or for that matter, 100 years before. The gold standard sharply restricted inflation by requiring that money created by the U.S. Treasury be backed by gold.

Although the U.S. economy grew rapidly throughout the gold standard years, the period was marked by a number of recessions associated with deflation and interest rate spikes. Sudden sustained short-term interest rate spikes of over 10 percentage points occurred on eight occasions between the Civil War and the founding of the Fed. Five of these episodes were accompanied by bank runs characterized by a demand to convert bank deposits into currency that could not be satisfied by the fractional gold reserves held by private banks. Major banking panics occurred in 1873, 1884, 1890, 1893, and 1907.

Finally, in response to the panic of 1907 and the ensuing recession, the nation set about to create a central bank. The U.S. Congress established the Fed and authorized it to create money somewhat independently of the nation’s monetary gold. The Fed was given the authority to create money by lending to banks or by buying securities in the financial market. The Fed’s mission was to provide an elastic supply of money in order to prevent interest rate spikes, while preserving the link between money and gold in the long run to maintain price stability.

The Fed succeeded in smoothing short-term interest rates. The problem was that by smoothing interest rates, the Fed was obliged to substitute its discretionary management of short rates for the impersonal market forces that had determined short rates for decades in the context of the gold standard. The Fed was without clear operational procedures for positioning short-term interest rates to stabilize economic activity around full employment with stable prices. Furthermore, the nation became reluctant to gear monetary policy to the rules of the gold standard even over the long term. Hence, the gold standard no longer served to anchor the general level of prices over time.

Deflation, Inflation, and the Restoration of Price Stability
Improvements in monetary policy that seemed within reach after the founding of the Fed proved elusive. The period of the Great Depression in the 1930s saw the sharpest deflation, the worst banking crisis, and the longest and deepest economic recession in U.S. history. Then, beginning in the mid-1960s, two decades of unprecedented peacetime inflation led to a tripling of the general price level by the early 1980s. The inflationary period was characterized by “go-stop monetary policy” in which unstable inflation generated numerous fluctuations in output and employment.

The Fed restored low inflation in the mid-1980s. Macroeconomic performance since then has been relatively good, especially when compared to the preceding inflationary period. The country experienced a mild recession in 1990-91 that was followed by the longest economic expansion in its history. That expansion ended with the recession that began in March 2001. For the most part, the period has featured strong employment growth and a pick-up in productivity growth. Both long- and short-term interest rates are much lower than they were in the 1970s and early 1980s, and they are much less volatile too.

Why has it taken so long for the Fed to give pride of place to price stability? Initially, Fed policy-makers underestimated the disruptive potential of inflation and were willing to tolerate each new burst of inflation in the hope that it would soon die down. Such hope seemed reasonable, since protracted peacetime inflation had never before been a problem in the United States. Prior to the 20th century, the world had little experience with monetary regimes in which money was unbacked by a commodity such as gold or silver.

Inflationary Go-Stop Monetary Policy at Mid-Century
A central bank such as the Fed charged with conducting monetary policy on a discretionary basis was naturally inclined to give considerable weight to the public’s mood. Go-stop monetary policy was, in large part, a consequence of the Fed’s inclination to be responsive to the shifting balance of public concerns about inflation and unemployment.

For the most part, the public tolerated inflation as long as it was low, steady, and predictable.When labor markets were slack, the public was even willing to risk higher inflation in order to stimulate additional economic activity. Only when the economy was strong and inflation moved well above the prevailing trend did inflation top the list of public concerns.

A persistent movement of inflation above its previous trend causes anxieties because people wonder where a new trend might be established. Lenders worry about how much of an inflation premium to demand in interest rates; businessmen worry about how aggressively to price in order to cover rising costs; and workers worry about maintaining the purchasing power of their wages.

In contrast to inflation, which affects all, unemployment actually affects relatively few at a given time. The unemployment rate in recent recessions has remained below 10 percent of the labor force. The public is concerned about unemployment not so much because of those who are unemployed but because people are afraid of becoming unemployed. It follows that the public is more concerned about unemployment when the unemployment rate is rising, even if it is still low, than when it is falling, even if the unemployment rate is already high.

This reasoning explains why the Fed produced inflationary go-stop monetary policy in the 1960s and 1970s. In retrospect, one observes the following pattern of events.

First, because inflation became a major concern only after it clearly moved above its previous trend, the Fed did not tighten monetary policy early enough to preempt inflationary outbursts before they became a problem.

Second, by the time the public became sufficiently concerned for the Fed to act, businesses setting prices and wages had already begun to factor higher inflation expectations into their decisions. Thus, delayed, restrictive monetary policy required a more aggressive increase in short-term interest rates with greater risk of recession.

Third, it was probably easier for the Fed to maintain public support for fighting inflation with prolonged rather than preemptive tightening. A more gradual lowering of interest rates in the later stage of a recession was a less visible means of fighting inflation than raising rates more sharply earlier. Once unemployment peaked and began to fall, the public’s anxiety about it diminished. Prolonged tightening was attractive as an inflation-fighting measure even though it probably lengthened the “stop” phase of the policy cycle.

Over time, go-stop policy resulted in rising inflation and interest rates. Deliberately expansionary monetary policy in the “go” phase of the cycle came to be anticipated by workers and firms. Workers learned to take advantage of tight labor markets to make higher wage demands, and firms took advantage of tight product markets to pass along higher costs in higher prices. Increasingly aggressive wage and price-setting behavior tended to neutralize the favorable employment effects of expansionary policy.

The Fed reacted by becoming evermore expansionary on average in its pursuit of low unemployment, causing correspondingly higher inflation and inflation expectations. Lenders demanded unprecedented inflation premiums in long-term interest rates, which reached around 15 percent per year in the early 1980s, by which time inflation had moved above 10 percent per year. When the Fed finally acted in the early 1980s to bring inflation down, it had to raise short-term interest rates above 20 percent per year and endure a protracted recession in which unemployment rose to around 10 percent.

Inflation Controlled: Lessons Learned and Principles Applied
One of the most important lessons learned from the last four decades is that effective monetary policy depends upon the widespread belief that the Fed will maintain low inflation. The Fed has acquired credibility for low inflation since the early 1980s by consistently taking policy actions to hold inflation in check. In effect, the Fed has established a mutual understanding between itself and the markets. Wage and price setters keep their part of an implicit bargain by not inflating as long as the Fed demonstrates its commitment to low inflation.

Experience shows that the guiding principle for monetary policy is to preempt rising inflation. The go-stop policy experience teaches that waiting until the public acknowledges rising inflation to be a problem is to wait too long. At that point, high inflation becomes entrenched and must be counteracted by corrective policy actions more likely to depress employment and production.

Our experience with low inflation also provides useful insights such as this. In years such as 1994, inflationary pressures seemed to call for an aggressive preemptive tightening; hence the Fed raised short-term interest rates from 3 to 6 percent to head off rising inflation. At other times, such as 1996, inflation might also seem to be a threat, but circumstances might suggest enough doubt to warrant a wait-and-see attitude.

The key to effective management of short-term interest rates over the business cycle is to move rates up decisively and preemptively when strong action is warranted to build credibility for low inflation. Actions that build credibility position the Fed to hold rates steady or move them down out of concern for unemployment at other times. Credibility enhances flexibility because it creates more leeway to cut interest rates to stimulate employment, without destabilizing inflation, inflation expectations, and long-term interest rates.

Conclusion
American monetary policy came full circle in the 20th century. The Federal Reserve embodied the idea that discretionary monetary policy could improve on the strict rules of the gold standard. Over time, the nation left the gold standard entirely for the freedom of a paper standard. But experience shows that the early faith in discretionary policy was somewhat misplaced. Today’s central bankers and monetary economists know that effective monetary policy must be built on a consistent commitment to price stability.

It is worth emphasizing that the priority for price stability derives not from any belief in its intrinsic merit relative to other goals such as full employment and economic growth. Price stability deserves a high priority for two reasons: first, the Fed actually has the power to guarantee it over time; and, second, monetary policy encourages employment and economic growth in the long run mostly by controlling inflation. Finally, and to reiterate, by anchoring inflation and inflation expectations, the Fed better positions monetary policy to address instability in financial markets and to stabilize employment and output in the short run.