P1: SBT 9780521881326pre CUNY1202/Hetzel 978 0 521 88132 6 February 25, 2008 16:9 This page intentionally left blank ii P1: SBT 9780521881326pre CUNY1202/Hetzel 978 0 521 88132 6 February 25, 2008 16:9 THE MONETARY POLICY OF THE FEDERAL RESERVE The Monetary Policy of the Federal Reserve details the evolution of the monetary standard from the start of the Federal Reserve through the end of the Greenspan era. The book places that evolution in the context of the intellectual and political environment of the time. By understanding the fitful process of replacing a gold standard with a paper money standard, the conduct of monetary policy becomes a series of experiments useful for understanding the fundamental issues concerning money and prices. How did the recurrent monetary instability of the twentieth century relate to the economic instability and to the associated political and social turbulence? After the detour in policy represented by FOMC chairmen Arthur Burns and G. William Miller, Paul Volcker and Alan Greenspan established the monetary standard originally foreshadowed by William McChesney Martin, who became chairman in 1951. The Monetary Policy of the Federal Reserve explains in a straightforward way the emergence and nature of the modern, inflation-targeting central bank. Robert L. Hetzel is Senior Economist and Policy Adviser in the Research Depart- ment of the Federal Reserve Bank of Richmond, where he has served for more than 30 years. Dr. Hetzel’s research has appeared in publications such as the Journal of Money, Credit, and Banking; the Journal of Monetary Economics; the Monetary and Economics Studies series of the Bank of Japan; and the Carnegie-Rochester Confer- ence Series.His writings provided one of the catalysts for the congressional hearings and treasury studies leading to the issuance of Treasury Inflation Protected Secu- rities, or TIPS. Dr. Hetzel has given seminars or served as a visiting scholar at the Austrian National Bank, the Bank of England, the Bank of Japan, the Bundes- bank, the European Central Bank, the National Bank of Hungary, and the Center for Research into European Integration in Bonn, Germany. He received his Ph.D. in 1975 from the University of Chicago, where Nobel Laureate Milton Friedman chaired his dissertation committee. i P1: SBT 9780521881326pre CUNY1202/Hetzel 978 0 521 88132 6 February 25, 2008 16:9 ii P1: SBT 9780521881326pre CUNY1202/Hetzel 978 0 521 88132 6 February 25, 2008 16:9 STUDIES IN MACROECONOMIC HISTORY series editor: Michael D. Bordo, Rutgers University editors: Marc Flandreau, Institut d’Etudes Politiques de Paris Chris Meissner, University of California, Davis Franc¸ois Velde, Federal Reserve Bank of Chicago David C. Wheelock, Federal Reserve Bank of St. Louis The titles in this series investigate themes of interest to economists and economic historians in the rapidly developing field of macroeconomic history. The four areas covered include the application of monetary and finance theory, international eco- nomics, and quantitative methods to historical problems; the historical application of growth and development theory and theories of business fluctuations; the his- tory of domestic and international monetary, financial, and other macroeconomic institutions; and the history of international monetary and financial systems. The series amalgamates the former Cambridge University Press series Studies in Mon- etary and Financial History and Studies in Quantitative Economic History. Other titles in the series: Howard Bodenhorn, AHistory of Banking in Antebellum America [987-0-521-66285-7; 978-0-521-66999-3] Michael D.Bordo,The Gold Standard and Related Regimes [978-0-521-55006-2; 978-0-521-02294-1] Michael D. Bordo and Forrest Capie (eds.), Monetary Regimes in Transition [978-0-521-41906-2; 978-0-521-03042-7] Michael D. Bordo and Roberto Cortes-Conde´ (eds.), Transferring Wealth and Power from the Old to the New World [978-0-521-77305-8; 978-0-521-02727-4] Richard Burdekin and Pierre Siklos (eds.), Deflation: Current and Historical Perspectives [978-0-521-83799-6] Trevor J. O. Dick and John E. Floyd, Canada and the Gold Standard [978-0-521-40408-2; 978-0-521-61706-2] Barry Eichengreen, Elusive Stability [978-0-521-36538-3; 978-0-521-44847-5] Continued after the Index iii P1: SBT 9780521881326pre CUNY1202/Hetzel 978 0 521 88132 6 February 25, 2008 16:9 To my great teacher, Milton Friedman, and to my steadfast companion in life, my wife iv P1: SBT 9780521881326pre CUNY1202/Hetzel 978 0 521 88132 6 February 25, 2008 16:9 The Monetary Policy of the Federal Reserve AHistory ROBERT L. HETZEL Federal Reserve Bank of Richmond v CAMBRIDGE UNIVERSITY PRESS Cambridge, New York, Melbourne, Madrid, Cape Town, Singapore, São Paulo Cambridge University Press The Edinburgh Building, Cambridge CB2 8RU, UK Published in the United States of America by Cambridge University Press, New York www.cambridge.org Information on this title: www.cambridge.org/9780521881326 © Robert L. Hetzel 2008 This publication is in copyright. Subject to statutory exception and to the provision of relevant collective licensing agreements, no reproduction of any part may take place without the written permission of Cambridge University Press. First published in print format 2008 ISBN-13 978-0-511-38825-5 eBook (NetLibrary) ISBN-13 978-0-521-88132-6 hardback Cambridge University Press has no responsibility for the persistence or accuracy of urls for external or third-party internet websites referred to in this publication, and does not guarantee that any content on such websites is, or will remain, accurate or appropriate. P1: SBT 9780521881326pre CUNY1202/Hetzel 978 0 521 88132 6 February 25, 2008 16:9 Contents Figures page ix Preface xiii 1The Pragmatic Evolution of the Monetary Standard 1 2Learning and Policy Ambiguity 6 3From Gold to Fiat Money 11 Appendix: Borrowed-Reserves Operating Procedures 32 4FromWorldWar IItotheAccord 34 Appendix: Series on the Real Interest Rate 45 5Martin and Lean-against-the-Wind 49 6Inflation Is a Nonmonetary Phenomenon 60 7The Start of the Great Inflation 67 8ArthurBurns and Richard Nixon 77 Appendix: Monetary Policy Procedures under Burns 96 Appendix: Money Growth and Inflation 99 9BrettonWoods 100 10 Policy in the Ford Administration 108 11 Carter, Burns, and Miller 117 Appendix: Did the FOMC Target Money in the 1970s? 129 12 The Political Economy of Inflation 132 Appendix: Revenue from the Inflation Tax 148 13 The Volcker Disinflation 150 Appendix: October 6, 1979, Operating Procedures 166 14 Monetary Policy after the Disinflation 172 Appendix: Borrowed-Reserves Operating Procedures 190 vii P1: SBT 9780521881326pre CUNY1202/Hetzel 978 0 521 88132 6 February 25, 2008 16:9 viii Contents Appendix: Monetary Policy Actions in 1986 191 Appendix: Velocity-Adjusted M2 Growth 194 15 Greenspan’s Move to Price Stability 196 16 International Bailouts and Moral Hazard 206 Appendix: Seigniorage and Credit Allocation 215 17 Monetary Policy Becomes Expansionary 218 18 Departing from the Standard Procedures 227 19 Boom and Bust: 1997 to 2001 234 20 Backing Off from Price Stability 244 Appendix: Japanese Deflation and Central Bank Money Creation 250 21 The Volcker–Greenspan Regime 252 Appendix: An Empirical Overview of the V–G Regime 265 Appendix: FOMC Data 269 22 The Fed: Inflation Fighter or Inflation Creator? 272 Appendix: Taylor Rule Estimation 276 23 The Stop–Go Laboratory 280 24 Stop–Go and Interest Rate Inertia 287 Appendix: A Taxonomy of Stop–Go 295 Appendix: Data Seen by FOMC for Stop–Go Period 302 25 Monetary Nonneutrality in the Stop–Go Era 303 26 A Century of Monetary Experiments 311 Appendix: Data Seen by FOMC for the Stop–Go Period Shown in Figures 24.1, 24.2, and 24.3 319 Notes 325 Bibliography 357 Index 379 P1: SBT 9780521881326pre CUNY1202/Hetzel 978 0 521 88132 6 February 25, 2008 16:9 Figures 3.1. Inflation page 15 3.2. Money Market and Discount Rates of Interest 19 3.3. Federal Reserve Credit and Currency Held by Public 24 3.4. M2 Growth 26 3.5. M1 Velocity 28 3.6. M2 Velocity 29 3.7. Real GNP Growth 31 4.1. Index of Wholesale Commodity Prices, United States: 1800–1941 38 4.2. Index of Wholesale Commodity Prices, England: 1640–1930 39 4.3. Inflation and M1 Growth 41 4.4. Livingston Survey: Predicted and Subsequently Realized One-Year Inflation 43 4.5. The One-Year Market Interest Rate on Government Securities and the Corresponding Real Rate of Interest 44 5.1. CPI Inflation 50 5.2. Government Bond and Three-Month Treasury Bill Yields 53 5.3. Rate of Growth of Real GDP 54 5.4. Money Growth 56 6.1. Unemployment Rate 62 6.2. Gross National Product, Actual and Potential, and Unemployment Rate 64 8.1. Price Performance and Unemployment 78 8.2. M1 Growth and the Funds Rate 82 8.3. Short-Term Real Commercial Paper Rate 83 8.4. Greenbook Predicted and Actual Inflation 90 12.1. Federal Revenues and Expenditures (percentage of GDP) 138 12.2. Federal Government Surplus or Deficit (percentage of GDP) 139 12.3. Federal Expenditure on Domestic Social Programs (percentage of GDP) 139 ix P1: SBT 9780521881326pre CUNY1202/Hetzel 978 0 521 88132 6 February 25, 2008 16:9 x Figures 12.4. Federal Expenditures on Defense and Expenditures Other Than on Domestic Social Programs (percentage of GDP) 140 12.5. Federal Transfer Payments to Individuals (percentage of GDP) 141 12.6. Federal Expenditures Out of General Revenue on Domestic Social Programs (percentage of GDP) 142 12.7. Personal Income Taxes as a Percentage of Personal Income 144 12.8. Indices of OASI Average Monthly Benefit and Average Hourly Earnings in Manufacturing 146 13.1. Money and Target Ranges 158 13.2. Actual and Predicted Real Output Growth 159 13.3.