It's hard to teach a central bank new tricks
By Scott Sumner
How did the Fed do during its first 100 years? For a deeper look at this question, you should read Selgin, Lastrapes and White. Here I’ll take a very broad overview, and look at a few key themes.
In my view, the Fed has committed three major policy errors: the Great Depression, the Great Inflation and the Great Recession. Fed officials such as Ben Bernanke have acknowledged that the Fed was to blame for the first two, but we’ll have to wait a few decades before we get a widely accepted view of the third failure.
All three major policy failures have something in common—the Fed was faced with a policy environment that was completely unanticipated when the Fed was first created. And in each case they proved unable to quickly adapt to that new and unforeseen environment. In the first two cases they did eventually adapt, and I hope and expect they will eventually adapt one again.
Here are the three unforeseen policy environments:
1. The Fed was created in 1913, right before WWI. Soon after, the war pushed the value of gold dramatically lower, as European powers sold off gold to finance military spending. After the war, many European countries took some time to return to gold. During that period the value of gold remained artificially depressed. The Fed did not know how to adapt to a world where the value of gold was artificially depressed, and likely to rise sharply as things returned to “normal.” (Recall that a rising value of gold was deflationary under a gold standard.)
2. The Fed was created during a period where it was assumed that the price of gold would remain stable. It was stable at $20.67 and ounce up to 1933, and then at $35 an ounce from 1934 to April 1968. But then the free market price of gold in Europe began rising above $35/oz. In a sense, 1968 is the year the US transited from a commodity money regime (with temporary periods of suspension) to a pure fiat regime, where the expected rate of inflation is not anchored by a commodity price peg. At first, the Fed proved unable to operate a fiat money regime. Eventually they learned how to control inflation (the Taylor Principle.)
3. The Fed had traditionally relied on interest rate targeting as a means of steering monetary policy. When nominal rates hit zero in late 2008, the Fed proved unable to adapt to the new environment. They sharply undershot their implicit aggregate demand targets. Once again, I believe they will eventually learn to adapt to this new environment. In this recent post I point out that there are signs the Fed is considering the market monetarist proposal for negative interest on bank reserves. I hope and expect that the Fed will eventually adopt other ideas, such as level targeting and NGDP targeting.
In Europe the unforeseen problems were slightly different. Unlike in the US, the ECB did not face the zero bound problem during 2008-12. Instead they faced several other unanticipated problems. In 2010 and 2011, it turned out that the policy that was likely to produce on target inflation in the eurozone would not even come close to producing macroeconomic stability. In addition, the “one-size-fits-all” problem turned out to be far more severe than the founders of the ECB had anticipated. And you could add that they also didn’t foresee the risk of sovereign debt default in multiple countries, creating contagion risk.