Free A History of the Federal Reserve, Volume 2 by Allan H. Meltzer

Reserve. Paul A. Volcker became chairman of the Board of Governors.

    Volcker was an anti-inflationist and a “practical monetarist.” Within two months of becoming chairman, he convinced the FOMC that it had to control money growth and allow interest rates to move as much as required to slow inflation.
    Volcker restored Federal Reserve independence and made a major change in its policy views. Instead of the belief that the economy required guidelines to reconcile low inflation and low unemployment, Volcker claimed that low inflation would encourage expansion and employment. The Federal Reserve’s goal changed to reducing inflation.
    Chapter 8 discusses policy actions from 1979 to 1982. With strong support from President Reagan and principal members of Congress, inflation fell to 4 percent by the end of 1982. The unemployment rate rose above 10 percent by fall 1982. A high unemployment rate, credit difficulties in the banking system caused by defaults on foreign loans, and congressional pressure brought a change in monetary policy in the summer and fall of 1982. The Federal Reserve returned to control of member bank borrowing and gave up efforts to control money growth. But it did not return to an inflationary policy.
    The so-called experiment with monetary control is generally regarded as a failure. The experiment was never complete; the FOMC considered but did not adopt institutional changes that would have improved its ability to control money growth. Also, large changes in the public’s asset allocation followed after Congress deregulated banking and financial markets. These changes made it difficult to interpret changes in monetary aggregates during the transition to a less regulated system.
    Volcker distrusted forecasts and relied more on his judgment and interpretation than on economic models. His “practical monetarism” did not go much beyond a belief that money growth above output growth was a necessary condition for inflation. His courage and determination to lower inflation showed in his willingness to raise interest rates despite relatively high and rising unemployment.
    Chapter 9 discusses actions taken from 1982 through 1986. Expectations of inflation as reflected in long-term interest rates and exchange rates (Charts 1.4 and 1.7 above) declined slowly. I date the end of the inflation in 1986, when the public seemed to accept that high inflation would not return soon.
    Chairman Volcker and the FOMC did not follow any explicit economic theory. Volcker relied on his assessment of events and his guesses about the future. He gave most attention to member bank borrowing, and he denied that he used an interest rate target. The FOMC was more alert to inflation than in the 1960s and 1970s.

    Chapter 10 concludes the volume. Federal Reserve policy remained much better than earlier until the mid-2000s. The economy experienced three long expansions followed by two relatively mild recessions. Variability of output and inflation declined; many called it “the great moderation.”
    I suggest some changes to improve monetary policy further. Although efforts to focus on longer-term objectives have been made, more needs to be done. The Federal Reserve needs to announce two strategies—one to guide its monetary policy operations, the other to guide its operations as lender of last resort. And it must insist on maintaining independence.
    The history of an institution is a record of successes and failures. I have suggested principal reasons for the failures—the inability to agree on a broad framework for analyzing events, a failure to focus on medium- to long-term outcomes, and the difficulty or inability to resist political pressures much of the time. At the time of its creation, proponents and opponents recognized a principal issue: Would the Federal Reserve be controlled by bankers operating in their interest or by politicians operating in theirs? Over time, control shifted to the Board of Governors. Resistance to