21st Century Monetary Policy

Book Preface

ON JANUARY 29, 2020, JAY POWELL strode briskly to the podium to begin the first press conference of his third year as chair of the Federal Reserve. He flipped open a white binder, looked up briefly to welcome the assembled reporters, and then looked down to read his prepared statement. His demeanor was low-key, almost somber. But his message was upbeat: The U.S. economy had entered the eleventh year of a record-long expansion, unemployment remained at a half-century low, and people in lower-paying jobs were seeing wage gains after years of stagnation. The trade tensions that had roiled financial markets for the past two years had diminished and global growth seemed to be stabilizing.

In passing, he noted “uncertainties” affecting the economic outlook, “including those posed by the new coronavirus.”^*1 A follow-up question on the virus, from Donna Borak of CNN, did not come until 21 minutes into the 54-minute press conference. At that point, only a few cases had been reported outside China. The virus, Powell cautiously acknowledged, was “a very serious issue” that could cause “some disruption to activity in China and possibly globally.” ²

Five weeks later, on March 3, Powell walked to the same podium and in the same calm tone read a much darker statement to reporters. He offered his sympathy to people the virus had harmed around the world, noted that it had disrupted the economies of many countries, and predicted that measures to contain the virus “will surely weigh on economic activity both here and abroad for some time.” The Fed, he said, was cutting interest rates “to help the economy keep strong in the face of new risks.”³ He hinted at more to come. The state of the world had changed dramatically—and the Fed’s policy had changed with it.

Between the January 29 and March 3 press conferences, the virus had evolved from a localized problem to an incipient global crisis. Reported cases of the disease that would become known as COVID-19 had risen from fewer than 10,000, almost all in China, to more than 90,000 worldwide. Italy had quarantined towns in its Lombardy region and Iran had reported a surge of infections. In the United States, the first virus death was reported on February 29—a man in his 50s, near Seattle. U.S. cases, and deaths, grew exponentially from there, threatening to overwhelm health-care systems in New York City and other hot spots.

Meanwhile, virus fears triggered the worst week in U.S. financial markets since the 2007–2009 financial crisis, signaling trouble ahead for the economy. The Dow Jones Industrial Average, which had hit a record high earlier in the month, plunged more than 12 percent during the week ending February 28. In March the turmoil spread to bond markets. Sellers of even ultrasafe U.S. Treasury securities had difficulty finding buyers, who showed little interest in holding anything other than cash. The markets for private credit, where corporations, home buyers, and state and local governments borrow, threatened to freeze entirely as lenders and investors grappled with coronavirus-induced uncertainty.

The market’s panic attack did, in fact, presage economic trauma. With businesses and schools closing, either voluntarily or under lockdowns imposed by local governments, economic activity contracted at an unprecedented rate. In February 2020, following a long recovery from the Great Recession, only 3.5 percent of the labor force was unemployed. Two months later, in April, the official unemployment rate stood at 14.8 percent, a shocking increase that likely understated the damage to the labor market. More than 20 million jobs were lost in April, by far the largest drop recorded since the data series began in 1939. The Business Cycle Dating Committee of the National Bureau of Economic Research, the arbiter of the timing of recessions and expansions, would later date the start of the pandemic recession to February.

Having served as Fed chair during the 2007–2009 global financial crisis, I had some idea of the stress that Powell and his colleagues at the Fed were experiencing. But, unlike the crisis we faced a dozen years earlier—which played out over nearly two years—this one seemed to happen all at once. On the principle that it’s better to get ahead of a crisis when you can, the Powell Fed quickly took a remarkable range of actions to calm the financial turmoil and protect the economy. It took its short-term interest rate target close to zero and promised to hold it there for as long as needed. To help restore normal functioning in money markets and Treasury debt markets, it lent to cash-strapped financial firms and bought hundreds of billions of dollars’ worth of Treasury and mortgage-backed securities on the open market. It reinstituted financial crisis–era programs to support business and consumer credit markets. Working with foreign central banks, it ensured global markets an adequate supply of dollars, the world’s reserve currency. And it would ultimately promise to continue its large-scale purchases of securities—a policy known as quantitative easing—until economic conditions improved substantially.

All of those measures were drawn from a playbook developed during the 2007–2009 crisis. But the Powell Fed did not stop there. It worked with Congress and the Treasury Department to establish new programs to backstop corporate and municipal bond markets and to finance bank loans to medium-sized businesses and nonprofit organizations. And in August 2020 it announced important changes to its monetary policymaking framework—the outcome of a process begun before the pandemic struck—aimed at making policy more powerful when interest rates are already low. In the ensuing months, it fleshed out its monetary approach by making more explicit its promises to keep interest rates low for as long as needed.

Of course, the Federal Reserve could do nothing to affect the course of the virus, the ultimate source of the crisis. Nor could it tax and spend to support the people and businesses most affected by the disease, as the administration and Congress could. But it could use both monetary policy and its lending powers to provide stability to the financial system, smooth the flow of credit to the economy, support consumer and business spending, and promote job creation. In doing so, it would play a substantial role in bridging the economy to the recovery that would follow the pandemic.

As I often remarked when I led the Fed, monetary policy is not a panacea. But money matters—a great deal. And, as the responses of the Powell Fed to the pandemic illustrate, monetary policy in the 21st century—and central banking more generally—has been defined by remarkable innovation and change. The Fed’s varied and sweeping actions during the pandemic, and the speed at which they were decided upon and announced, once would have seemed inconceivable—not only to the Fed of the 1950s and 1960s, chaired by the first modern Fed leader, William McChesney Martin Jr., but even to the Fed of the 1990s, led by one of history’s most influential central bankers, Alan Greenspan. As Powell himself would acknowledge, “We crossed a lot of red lines that had not been crossed before.”⁴

The aim of this book is to help readers understand how the Federal Reserve, the steward of U.S. monetary policy, got to where it is today, what it has learned from the diverse challenges it has faced, and how it may evolve in the future. Although my account focuses on the Fed, the central bank I know best, I also draw on the experiences of other major central banks, which have faced many of the same challenges and have made important innovations of their own. I hope this book will be useful to my fellow economists and their students, but I have tried to make it accessible to anyone with an interest in economic policy, finance, or central banking. As the role played by the Powell Fed in the pandemic crisis makes clear, an appreciation of the goals of the Federal Reserve, and of the tools and strategies it uses to meet those goals, is essential for understanding the contemporary global economy.

THE HISTORICAL LENS

This book examines today’s (and tomorrow’s) Federal Reserve primarily through an historical lens. That’s how I came to the subject, and I see no other way to understand completely how the Fed’s tools, strategies, and communication have evolved to where they are today.

A conversation I had as a graduate student at the Massachusetts Institute of Technology (MIT) in the late 1970s kindled my interest in monetary policy. I went to a young professor, Stanley Fischer—then a rising academic star, later a governor of the Bank of Israel and vice chair of the Federal Reserve—looking for advice on a dissertation topic. Stan, who would become my adviser and mentor, handed me a copy of the 860-page A Monetary History of the United States, 1867–1960, by Milton Friedman and Anna Schwartz.⁵

“Read this,” Stan said. “It may bore you to death. But if it excites you, you might consider doing monetary economics.”

The book fascinated me. It got me interested not only in monetary economics, but also in the causes of the Great Depression of the 1930s, a topic that I would return to frequently in my academic writings. As Friedman and Schwartz showed, central bankers’ outmoded doctrines and flawed understanding of the economy played a crucial role in that catastrophic decade, demonstrating the power of ideas to shape events. It’s in the spirit of Friedman and Schwartz that this book uses history to explain the evolution of the Fed’s policies and role in the economy. And since Friedman and Schwartz left off their history in the decades after World War II, the immediate postwar era seems an appropriate place to start this narrative. Learning the lessons of the Fed’s history prepares us to speculate about the future as well, as I do in the final part of the book.

Indeed, in many ways, the 1950s and early 1960s mark the beginning of modern central banking. By that time, the Fed was no longer constrained by the gold standard of the 1920s and 1930s, or by the responsibility, assumed during World War II, to help finance wartime debts by keeping interest rates low. It was also a time when the ideas of the British economist John Maynard Keynes were becoming increasingly influential in the United States. Keynes died in 1946, but his followers built on his Depression-era writings to highlight the potential of macroeconomic policies, including monetary policy, to fight recessions and control inflation. So-called Keynesian economics, in a modernized form, remains the central paradigm at the Fed and other central banks.

The 1960s also saw the beginning of one of the most traumatic economic events of postwar U.S. history, as well as one of the signal failures of economic policymaking—what we now call the Great Inflation. Until it was conquered (at a high cost in lost jobs) by Paul Volcker’s Fed in the 1980s, the Great Inflation threatened U.S. economic and even political stability. What policymakers learned, or thought they learned, from the Great Inflation shaped the evolution of monetary policy, and continues to shape it, even today.

THE FEDERAL RESERVE: SOME BACKGROUND

To lay some groundwork, I’ll sketch here some early history of U.S. central banking and provide background on the Fed—its structure, how it is governed, and how it implements its monetary policy decisions. I’ll then preview the critical factors that, this book will argue, shaped the modern Fed and motivated the remarkable changes in its tools and policies in recent decades.

Early Years

America has a strong populist tradition, and populists—from President Andrew Jackson to, more recently, members of the Tea Party and Occupy Wall Street—have always been hostile to perceived concentrations of power in finance and government. Populist influences help explain why the United States lacked a well-established central bank until the creation of the Federal Reserve in 1913, later than many other advanced economies (the Bank of England dates back to 1694, Sweden’s central bank even earlier). Alexander Hamilton—the country’s first Treasury secretary and a modernizer who understood that America would one day be an industrial and financial power—initiated a central bank in 1791, but only over the bitter opposition of Thomas Jefferson and James Madison, who had more-pastoral visions for the U.S. economy. The charter of Hamilton’s First Bank of the United States was allowed to lapse in 1811, on a narrow congressional vote. Another attempt at establishing a central bank, the Second Bank of the United States, also was dashed when, in 1832, President Jackson—who distrusted banks in general and feuded with the Second Bank’s leader, Nicholas Biddle—vetoed Congress’s renewal of its charter. (It’s ironic that Jackson’s likeness remains on the $20 Federal Reserve note. He would have objected.)

The political environment of the Progressive Era, from roughly the 1890s to the 1920s, was more conducive to the establishment of a central bank. President Woodrow Wilson did just that by signing the Federal Reserve Act on December 23, 1913. Consistent with progressive views of the time, which advocated scientific, rational policies to improve the economy, the new Federal Reserve System was intended to oversee and help stabilize America’s lightly regulated and often-dysfunctional banking system. The 19th century American banking system had been afflicted by frequent runs and panics, which were almost always associated with recessions, some of them quite severe. The panic of 1907—ended by the intervention of the famed financier J. Pierpont Morgan and his allies, not the government—was the last straw. Congress grew determined to revisit the idea of a central bank.

The Bank of England, the world’s most important central bank at the time, provided a model. It had two primary responsibilities. First, it managed Great Britain’s money supply consistent with the gold standard. The pound, like other major currencies, had a fixed value in terms of gold, and the Bank adjusted short-term interest rates to ensure the pound’s gold value remained stable. Second, and particularly relevant to the United States, it served as a lender of last resort during runs and panics. If depositors lost confidence in British banks or other financial firms and lined up to withdraw their money, the Bank of England stood ready to lend the banks the cash they needed to pay off depositors, taking the banks’ loans and other assets as collateral. So long as a bank was fundamentally solvent, the Bank of England’s loans would allow it to remain open and avoid selling off their assets at fire sale prices. Great Britain thus avoided the pattern of recurring financial crises and economic instability that had plagued the United States in the 1800s and early 1900s.

Like the Bank of England, the newly created Federal Reserve was given the critical roles of managing the money supply (as dictated by the gold standard) and serving as lender of last resort for banks that chose to join the Federal Reserve System—so-called member banks.^† Since only solvent banks were eligible to borrow from the Fed, the new central bank was also given authority to examine member banks’ books, authority it shared with the Comptroller of the Currency (established during the Civil War to oversee nationally chartered banks) and state banking regulators (who supervised state-chartered banks). To this day, monetary policy, bank supervision, and responding to threats to financial stability are a pretty good description of the Fed’s main responsibilities.

There had been an ongoing debate about whether the new central bank would be managed from Washington (as advocated by most bankers) or in a more decentralized way that gave greater power to regional branches of the central bank (the model preferred by midwestern farmers and others who feared the concentrated power of eastern financial interests). Wilson backed a compromise: The Federal Reserve System would consist of both a Board of Governors in Washington with general oversight powers and up to twelve regional Federal Reserve Banks, each with considerable autonomy, located in major cities across the country. Cities campaigned to be the sites of Reserve Banks, which were ultimately established in Boston, New York, Philadelphia, Cleveland, Richmond, Atlanta, Chicago, St. Louis, Minneapolis, Kansas City, Dallas, and San Francisco. These cities remain the locations of the Reserve Banks today, despite the westward shift of economic activity since the Fed was founded. (The San Francisco Fed’s district now includes more than one-fifth of U.S. economic activity.)

The Great Depression

The U.S. economy prospered, on balance, during the Fed’s first fifteen years, but in 1929 the world entered a global depression. The origins of the Great Depression are complex, but the international gold standard, which had been reinstituted following its suspension by most countries during World War I, was a principal cause. The war had been accompanied by substantial inflation, as the government finances of belligerent countries crumbled and shortages of critical commodities multiplied. As countries returned to the gold standard after the war, reestablishing the link between the supply of money and the quantity of available gold, it became evident that there was not enough gold in the world, nor was it distributed evenly enough among countries, to sustain the prices of goods and services at their new, higher levels.

One solution would have been to reduce the official values of currencies relative to gold, allowing the available gold to support higher money supplies and price levels, but in many countries currency devaluation was seen as inconsistent with the spirit of the gold standard. (Purchasers of government bonds were particularly opposed to devaluation, since it would reduce the real value of their bonds.) Instead, jury-rigged arrangements were developed to compensate for the shortage of gold. For example, some countries agreed to hold gold-backed currencies, like the British pound, in lieu of actual gold. The Bank of England itself, as had long been its practice, held a gold stock that was small compared to the number of paper pounds outstanding, relying on investor confidence in England’s commitment to the gold standard rather than actual gold to back the pound.

International political and financial conditions remained highly unstable after the war, however, exacerbated by disagreements over how much Germany should pay in reparations and American demands for the full repayment of its wartime loans to Great Britain and France. These conflicts in turn shook confidence in the reconstructed global monetary system, which relied heavily on mutual trust and cooperation. As fear and uncertainty grew, governments and investors stopped holding pounds and other gold surrogates and tried to obtain physical gold instead, resulting in a global “scramble for gold,” including runs on the gold held by central banks. As the global shortage of gold began to reassert itself, money supplies and prices collapsed in the gold-standard countries. The prices of U.S. goods and services, for example, fell by 30 percent from 1931 to 1933.

The deflation of the price level in turn bankrupted many debtors—think of farmers trying to pay their mortgages when crop prices were plummeting—which helped bring down the financial system and, with it, the economy.⁶ Runs by frightened depositors led to increasingly severe waves of bank failures—in the United States, thousands of mostly small banks closed their doors—which worsened financial distress, further reduced the money supply, and constricted credit to businesses and farmers. With few exceptions, the Depression was global although, consistent with the view that the gold standard was a major cause of the downturn, the economies of countries that chose or were forced to abandon the gold standard earlier also recovered more quickly.⁷

In 1933, newly elected President Franklin Roosevelt launched a barrage of new policies to try to end the Depression. Two were particularly important: First, FDR broke the link between the dollar and gold, which ended the U.S. deflation and allowed a nascent recovery, until premature monetary and fiscal tightening led to a new recession in 1937.^‡ Second, Roosevelt declared a banking “holiday,” closing all banks and vowing to reopen only those banks that were solvent. Together with the creation of federal deposit insurance by Congress, which protected small depositors from losses from bank failures, the holiday decisively ended the banking panics.

Friedman and Schwartz’s Monetary History underscored the role of the collapse in money and prices in creating the Great Depression. Shortly after I joined the Federal Reserve, as a member of the Board of Governors, I spoke at Friedman’s ninetieth birthday party. I concluded my remarks by apologizing for the Federal Reserve’s role in the catastrophe: “I would like to say to Milton and Anna: Regarding the Great Depression. You’re right, we did it. We’re very sorry. But thanks to you, we won’t do it again.”⁸

Blaming the Depression entirely on the Fed is an exaggeration, but the relatively new and unseasoned central bank did perform poorly. Its interest-rate increases in the 1920s, aimed at cooling speculation in the stock market, contributed to both the 1929 stock crash and the initial global downturn. Its commitment to the gold standard prevented it from responding adequately to the destructive deflation of the early 1930s. And it did too little to stem the waves of banking panics, even though ending panics had been one of the motivations for its creation.^§ The Fed’s failure to preserve either monetary or financial stability made the Great Depression much worse than it might otherwise have been.

A flawed intellectual framework—including adherence to the gold standard beyond its point of viability—was a key reason the Fed and other policymakers failed to avert the Depression. But another explanation for the Fed’s relative passivity during the 1930s crisis, stressed by Friedman and Schwartz, was its decentralized structure and lack of effective leadership. (Benjamin Strong, the influential governor of the Federal Reserve Bank of New York, and the de facto leader of the Fed system, had died of tuberculosis in 1928.) Congress addressed this weakness by revamping the organization of the central bank. As part of the Banking Act of 1935, it increased the power of the Federal Reserve Board in Washington and reduced the autonomy of the regional Reserve Banks, creating what remains today the Fed’s basic decision-making structure.

The reforms also increased the Fed’s independence from the executive branch by removing the Treasury secretary and the Comptroller of the Currency (the regulator of nationally chartered banks) from the Fed Board and—in an important symbolic step—by moving the Board from its previous location in the Treasury Department to a grand new headquarters—a Works Progress Administration project—on Constitution Avenue in Washington, facing the Mall. The building was later named for Marriner Eccles, Board chair from 1934 to 1948. Eccles was instrumental in crafting the Banking Act of 1935 and would ultimately fill the leadership void left by the death of Strong. In contrast to many of his predecessors at the Fed, Eccles recognized that forceful government action was necessary to counter the Depression, and his ideas—some of which anticipated the theories of Keynes—helped form the basis of Roosevelt’s New Deal.

The Depression lasted until the massive war effort of 1941–45 pushed the American economy to full employment and beyond. During and immediately after the war, at the Treasury’s request, the Fed held interest rates at low levels to reduce the government’s cost of financing the war. After the war, and facing new hostilities in Korea, President Truman pressed the Fed to keep rates low. But the Fed’s leaders worried that very low rates would stoke inflation, which had surged when the end of wartime rationing spurred demand for consumer goods. As we’ll see in Chapter 1, the Fed rebelled, and in March 1951 the Treasury and the Fed agreed that the Fed would phase out its interest-rate peg, leaving it free to use monetary policy to advance macroeconomic goals, including the stabilization of inflation. This historic agreement, known as the Treasury-Fed Accord of 1951, helped set the stage for modern monetary policy.

The Federal Reserve’s Structure

The Federal Reserve’s structure today largely reflects congressional choices made at its founding in 1913 and in the 1935 reforms.

As at its inception, the Federal Reserve System consists of a Board of Governors in Washington and twelve Reserve Banks. The seven members of the Board are nominated by the president and confirmed by the Senate to fourteen-year, staggered terms. The Board chair and vice chair—plus, since the passage of regulatory reforms in 2010, a second vice chair responsible for the oversight of bank supervision—are also nominated by the president and confirmed by the Senate to four-year terms. Unlike Cabinet secretaries, by law, Board members cannot be fired by the president for policy differences, but only for malfeasance or through impeachment by Congress.

Reflecting compromises made when the Fed was created, the twelve Reserve Banks are technically private institutions, though with a public purpose. Each has a board of directors, drawn from local bankers, businesspeople, and community leaders. These boards help oversee the operations of their Reserve Bank and, importantly, the directors (excluding, since 2010, the bankers) choose its president, subject to the approval of the Board in Washington.

Reflecting the 1935 reforms, as well as the fact that members of the Board—unlike Reserve Bank presidents—are presidential appointees, the Board today holds much of the Federal Reserve’s policymaking authority. Importantly, the Board is in charge of lender-of-last-resort policy; it sets the discount rate—the interest rate at which the Fed lends to banks—and determines whether to invoke the Fed’s emergency lending powers. The Board also establishes rules, such as capital requirements, for the banks and bank holding companies (companies that own banks and possibly other financial firms) that the Fed regulates and supervises.^¶ Staff at the regional Reserve Banks do the actual hands-on supervision of banks, ensuring that the banks in their district follow the rules set by the Board.

There is one very important exception to the principle that the Board sets Federal Reserve policies: monetary policy, which includes the setting of short-term interest rates and other measures aimed at affecting overall financial conditions and, through them, the health of the economy. By law, monetary policy is made by a larger group called the Federal Open Market Committee (the FOMC or the Committee, for short). The FOMC’s meetings are attended by nineteen policymakers (when there are no vacancies)—the seven Board members and twelve Reserve Bank presidents—along with staff from the Board and each of the Reserve Banks. By tradition, the Committee each year elects the Board chair as its chair. The FOMC meets eight times each year around a massive mahogany and black granite table in the boardroom of the Eccles building in Washington. The chair can also call unscheduled meetings, formerly held by phone and now by videoconference.

The voting rules of the FOMC are convoluted. Of the nineteen governors and presidents who attend and participate, only twelve vote at any given meeting. The seven Board members and the president of the Federal Reserve Bank of New York (who also by tradition serves as the vice chair of the FOMC) vote at every meeting. The remaining four votes rotate annually among the other eleven Reserve Bank presidents. This complex design allows the regional Reserve Bank presidents a voice but gives the majority (depending on Board vacancies) to the politically appointed Board members. In Fed lingo, the nineteen policymakers who attend FOMC meetings are called participants, while voters are called members.

The Fed chair, in his or her capacity as chair of the FOMC, has only one vote on monetary policy, but the ability to set the agenda and recommend policy actions, together with the Committee’s tradition of consensus decision-making, makes the chair a highly influential first among equals. The Board vice chair and the president of the Federal Reserve Bank of New York are also usually quite influential and work closely with the chair.

Ultimately, of course, the administration and Congress, through legislation, set the Fed’s goals, structure, and authorities. The cornerstone of congressional oversight of the Fed’s monetary policy, formally laid out in the Federal Reserve Reform Act of 1977, is the so-called dual mandate: Congress’s instruction to the FOMC to pursue the economic goals of maximum employment and stable prices. Although the Fed’s monetary policy objectives are enshrined in law, Fed policymakers are responsible for managing interest rates and other policy instruments to achieve those objectives. In a distinction popularized by Stanley Fischer, the Fed does not have goal independence—its objectives are set by the president and Congress, through legislation—but it does have, at least in principle, what I’ll call policy independence, the ability to use its policy instruments as it sees fit to best achieve those mandated goals.⁹ Various aspects of the Fed’s structure—including the long, overlapping terms of governors; the provision that governors cannot be fired by the president for policy differences; the fact that Reserve Bank presidents are not political appointees; and the Fed’s ability to pay for its operations out of the returns from the securities it owns rather than relying on congressional appropriations—help insulate it from short-term political pressures, allowing it to act more independently than Cabinet departments and with a greater focus on longer-term outcomes.

The Federal Reserve’s Balance Sheet and Monetary Policy

Like any bank, the Federal Reserve has a balance sheet with assets and liabilities.^# It has two principal liabilities: currency—cash, known as Federal Reserve notes—and bank reserves. A remarkably large amount of U.S. currency is in circulation—about $2.15 trillion in 2021, or more than $6,000 per each American. (Of course, few Americans hold that much cash; many dollars are held overseas, often as a hedge against inflation or instability of the local currency.)

Bank reserves are deposits that commercial banks hold at the Fed. (Cash held by banks in their vaults also counts as reserves.) Banks no longer have to hold reserves to satisfy regulatory requirements, as they did in the past, but they nevertheless find them useful. For example, if a bank in San Francisco needs to transfer funds to a bank in New York, it can do that easily by instructing the Fed to move reserves from its account to the account of the New York bank. Bank reserves are also safe and liquid, and can be quickly converted into cash to meet the needs of depositors.

A bank that wants additional reserves can borrow them from another bank, usually overnight. The interest rate that banks charge each other to borrow reserves is called the federal funds rate. Despite its name, the federal funds rate is a market-determined rate. However, the funds rate, for short, is a key interest rate for monetary policymakers. Throughout most of its modern history, the FOMC has implemented monetary policy through its ability to influence the funds rate, although at times the discount rate has also been used to signal monetary policy changes.

On the asset side of its balance sheet, the Fed’s principal holdings are U.S. Treasury securities (federal government debt) of varying maturities, as well as mortgage-backed securities (securities that bundle together large numbers of individual mortgages). The mortgage-backed securities held by the Fed are issued by the government-sponsored enterprises, or GSEs. The GSEs—organizations with the nicknames Fannie Mae, Freddie Mac, and Ginnie Mae—were created by the federal government to facilitate the flow of credit into the housing market. All the securities issued by the GSEs, which the Fed is allowed to buy and hold, are currently government-guaranteed. In addition, any loans the Fed makes—say, to a bank, in its role of lender of last resort—count as assets.

The Fed’s balance sheet typically provides substantial income. On the asset side, the Fed receives interest on the securities it holds. On the liability side, it pays interest on bank reserves but not on currency. It uses some of its income to pay for its own operations but remits most of it to the Treasury, thus reducing the government’s budget deficit.

Importantly, the Fed uses its balance sheet to implement its monetary policy decisions. Suppose higher interest rates are needed to achieve the FOMC’s economic goals. Having made that decision, the Committee would increase the target level (or, more recently, target range) for the federal funds rate.

In recent years, the Fed has influenced the funds rate by varying two administered rates, including the interest rate it pays banks on the reserves they hold at the Fed. Throughout most of its modern history, though, the Fed raised the funds rate by creating a shortage of bank reserves, which, in turn, caused the banks themselves to bid up the funds rate. To reduce the supply of bank reserves, the Fed, through the Open Market Desk at the Federal Reserve Bank of New York, sold Treasury securities to private investors, using a designated set of private financial firms called primary dealers as its agents. As investors paid for the securities, reserves in the banking system declined in equal measure. (Think of the purchasers of the securities as writing checks to the Fed; to settle those checks, the purchasers’ banks must draw down their reserves.) With fewer reserves available, the rate (price) that banks paid to borrow reserves from each other naturally rose, as intended by the FOMC. Likewise, to lower the federal funds rate (the price of borrowing reserves), the Open Market Desk bought Treasury securities on the open market, increasing the supply of reserves in the banking system. Other forms of monetary policy, including the large-scale securities purchases that constitute quantitative easing, also employ changes in the Federal Reserve’s balance sheet.

Because financial markets are closely linked, the Fed’s ability to change the federal funds rate allows it to affect financial conditions more broadly. Easy financial conditions promote borrowing and spending and thus economic activity. To ease financial conditions, the FOMC lowers its target for the funds rate, which then affects other financial variables. For example, a lower funds rate would normally be associated with lower rates on mortgages and corporate bonds (supporting spending on housing and capital investment), higher stock prices (increasing spending by raising wealth), and a weaker dollar (which encourages exports by making the prices of U.S. goods cheaper). To tighten financial conditions, the FOMC would raise its target for the funds rate, reversing the effects of easy policy.

THE THESIS OF THIS BOOK

As the response of the Powell Fed to the pandemic showed, the Fed’s tools, policy framework, and communications have changed radically since the 1951 Treasury-Fed Accord freed the central bank to pursue macroeconomic objectives. The unifying thesis of this book is that these changes have, for the most part, been the result not of changes in economic theories or in the Fed’s formal powers, but of three broad economic developments that, in combination, have shaped how the central bank sees its goals and constraints.

The first of these developments is the ongoing change in the behavior of inflation and, in particular, its relationship to employment. Since the 1950s, U.S. monetary policy has been heavily influenced by economists’ and policymakers’ views about the relationship between inflation and the labor market. Policymakers of the 1960s and 1970s both misjudged this relationship and failed to consider the destabilizing effects of what economists call “inflation psychology,” twin mistakes that contributed to a decade and a half of rapid price increases—the Great Inflation.

The restoration of the Fed’s inflation-fighting credibility in the 1980s and 1990s under chairs Volcker and Greenspan would have important benefits, and the control of inflation became central to the Fed’s policy strategy during that time. However, as we will see, subsequent years saw significant changes in the behavior of inflation, including an apparent marked weakening in the relationship between inflation and unemployment. Monetary policymakers also recognized, after 2000, that inflation can be too low as well as too high. These changes led to new policy strategies and tactics, including a new framework from Chair Powell’s Fed in August 2020. Then, in 2021, shortages and bottlenecks associated with reopening after the pandemic helped spark a sharp increase in inflation, despite the fact that employment remained well below pre-pandemic levels. Why has the behavior of inflation, including its relationship with employment, changed over time? What implications does this have for monetary policy and the economy, now and in the future?

The second development is the long-term decline in the normal level of interest rates. In part because of lower inflation, the general level of interest rates—even when monetary policy is not adding stimulus to the economy—is much lower than in the past. Importantly, that reduces the scope of the Fed and other central banks to cut interest rates to support the economy during downturns. In 2008, during the global financial crisis, and again in 2020, with the economy shut down by a pandemic, the federal funds rate hit zero, but the economy needed much more stimulus. How can the Fed and other central banks support the economy when short-term interest rates remain relatively close to zero? What tools have been used, how have they worked, and what new tools might be used in the future? What role should fiscal policy—government spending and taxation—play in stabilizing the economy?

The third and final long-term development is increased risk of systemic financial instability. The Fed was founded to help keep the financial system stable, to avoid panics and crashes that endanger the economy. It failed to achieve that during the Depression. Between World War II and the 2007–2009 global financial crisis, the United States faced periodic, but ultimately limited, threats to financial stability. The global financial crisis showed, however, that severe financial instability is not an historical curiosity or something that can happen only in emerging markets. It can happen in, and do terrible damage to, even the most advanced economies and the most sophisticated financial systems. The 2007–2009 crisis forced the Fed, during my term as chair, to develop new tools for fighting financial instability, and the Fed further expanded its crisis-fighting toolkit during the pandemic-era crisis of March 2020. Increased instability also motivated significant regulatory reforms and more-intensive monitoring of the financial system. Are those measures enough? What else can be done? To what extent, if any, should monetary policy take financial-stability risks into account?

These three factors are primarily economic, but understanding the Fed’s policy choices also requires attention to its political and social environment. Among the most important political determinants of Fed decision-making is the degree of independence the institution enjoys. As we’ve seen, aspects of the Fed’s structure, like the long terms of governors and budgetary autonomy, promote its policy independence. On the other hand, Congress could change the Fed’s structure and authorities at any time, and the Fed’s democratic legitimacy requires that it respond to the popular will as expressed through the legislative and executive branches. What is the modern case for central-bank independence? When should the central bank cooperate with the Treasury or other parts of the government? Should monetary and fiscal policy be more coordinated? Should the Fed have a role in the pursuit of broader social goals, such as reducing economic inequality or mitigating climate change?

The critical questions raised here cannot be answered in the abstract, but only by understanding the historical context in which these issues arose and in which Fed policy was made. Parts I to III of this book look at the evolution of Federal Reserve policies, as the Fed responded to a changing economic and political environment, from the early postwar period through the present. Part IV is forward looking, drawing on the lessons of this experience to consider current controversies and the future prospects of U.S. monetary policy and policies to maintain financial stability.

* The Note on Sources at the end of the book provides links to official Federal Reserve documents, including transcripts of press conferences and FOMC meetings, policy statements, press releases, meeting minutes, projections, and congressional testimonies. Endnotes throughout the book provide additional information as needed, including page references for direct quotes and references to older or less accessible materials. Speeches by Federal Reserve officials are separately cited.

† Banks with national charters were required to join the System but state-chartered banks could choose whether to join. The U.S. banking system today still has three types of banks: national banks, state-chartered banks that are members of the Federal Reserve System, and state nonmember banks, each with a different mix of regulators.

‡ Vestiges of the international gold standard remained until the 1970s, but after 1933 the gold standard placed essentially no constraints on Federal Reserve policies.

§ The reasons for the Fed’s failure to stop the banking panics of the 1930s are debated. Most banks at the time were small and undiversified and quickly became insolvent; they thus lacked collateral against which to borrow from the Fed. Many others were not members of the Federal Reserve System and thus were not eligible for Fed loans. Nevertheless, most historians agree that the Fed could have done more to stabilize the banking system.

¶ A bank’s capital is, roughly, the excess of its assets over its liabilities, which in turn equals the equity of its shareholders. Capital is available to absorb losses on loans and other investments without triggering bankruptcy, so a bank with a large amount of capital is at less risk of failing.

** More precisely, each regional Federal Reserve Bank has its own balance sheet, a relic of the time when each Reserve Bank served as an independent lender of last resort to banks in its district. Taken together, the regional Fed balance sheets make up the collective balance sheet of the Federal Reserve System.

CONTENTS

INTRODUCTION

PART I. 20TH CENTURY MONETARY POLICY

The Rise and Fall of Inflation

1. The Great Inflation

2. Burns and Volcker

3. Greenspan and the Nineties Boom

PART II. 21ST CENTURY MONETARY POLICY

The Global Financial Crisis and the Great Recession

4. New Century, New Challenges

5. The Global Financial Crisis

6. A New Monetary Regime: From QE1 to QE2

7. Monetary Evolution: QE3 and the Taper Tantrum

PART III. 21ST CENTURY MONETARY POLICY

From Liftoff to the COVID-19 Pandemic

8. Liftoff

9. Powell and Trump

10. Pandemic

PART IV. 21ST CENTURY MONETARY POLICY

What Lies Ahead

11. The Fed’s Post-2008 Toolkit: Quantitative Easing and Forward Guidance

12. Is the Fed’s Toolkit Enough?

13. Making Policy More Powerful: New Tools and Frameworks

14. Monetary Policy and Financial Stability

15. The Fed’s Independence and Role in Society

AN INVITATION TO COMMENT

ACKNOWLEDGMENTS

A NOTE ON SOURCES

NOTES

BIBLIOGRAPHY

INDEX

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