Monetary Policy: Part 2 - The Stable Decades

This next few posts discuss the operation of monetary policy from WWII through to 1980 when NOW accounts were suddenly introduced. These were the stable decades in terms of the operating environment, although they were anything but stable in terms of the results. The instability of results had nothing to do with the operating system, but everything to do with the operators, for the operators simply didn't understand how the system actually functioned.

The Perceived Role of Interest Rates

For most of the Fed's existence up through 1980 the economic theory relied upon, and espoused, by the Federal Reserve held that the level of interest rates govern economic activity. This remains true to the present day, by the way.

Thus, if the economy was slowing, the Fed would cut interest rates, while if it was growing too fast and inflation was beginning to surge, it would raise interest rates. Actually it would cut or raise the interest rate, that rate being the rate of interest paid on federal funds in the interbank market. The theory essentially states that rising rates will slow economic activity whereas falling rates will encourage economic activity. Of course, this is true as the activity in the housing market often demonstrates. But it's the wrong theory upon which to base the operation of monetary policy. It's a reactionary policy, and therefore too slow, leading inevitably to large swings in economic activity and inflation.

The Essential Role of Interest Rates

There is only one interest rate that really matters to monetary policy, and that rate is zero percent, for that is the one and only rate that should be allowed on all transaction balances, or what we know as demand deposits, or checking accounts. It's also the rate paid on cash, incidentally. No one earns interest on the cash in their pockets, nor should they be permitted to earn interest on balances in their banks that they intend to be used for immediate purchases.

Why is this important? Why is paying interest on checking a terrible idea? Because it renders the operating mechanism of a fractional reserve system useless. And how does it do that? It makes holders of checking account balances indifferent to how much they hold in checking and how much they hold in savings.

When interest was only paid on savings deposits, people rationally minimized their checking account balances, even when interest on savings was relatively low. Some interest is better than no interest, after all. Similarly, they minimized the cash in their pockets. Importantly, this remained true regardless of the level of interest rates on savings. Again, some interest is better than none and a lot of interest is even better yet, but checking accounts and cash were always minimized by their holders. And as long as they were minimized at the outset, the level of interest rates on savings and other alternatives mattered little to monetary policy. The key to an operational fractional reserve system is the minimization of cash and demand balances by their holders.

Where the Fed Erred in the Stable Decades

Because both cash and checking balances earned no interest, the fractional reserve system in place since the Fed's founding could operate as planned. The problem is that the Fed didn't operate it as planned. Instead, because they followed the economic theory that put the cart of interest rates ahead of the monetary horse, and decided to manage interest rates instead of required reserves. But doing so was painfully slow-acting and often just plain wrong. Time after time, the Fed could be shown to have been tightening (raising rates) well after the economy had already gone into recession.

It generally takes four to six months before a recession is even suspected, much less acknowledged. Acknowledgement might take several quarters. Similarly, the Fed can be shown many times in the past to have been easing well after the economy had already been heating back up. The operating policy using interest rates as a lever of policy suffered from too much lag time to be truly effective. In fact, because of that lag time the Fed really never knew if it had tightened enough but would worry that it had and pause in the effort. This often prolonged the entire process until the Fed finally got ahead of things (or so they thought) and the economy would finally slow (with the Fed still in tightening mode several months after.)

What those operating the Fed at the time failed to realize is that they possessed all they needed within the reserve requirement mechanism itself. Interest rates needed no consideration whatsoever, other than the need to keep short term rates somewhat positive at a minimum, a trivial exercise given their control over the fed funds market.

The next post or two will seek to explain how monetary policy actually operated in the stable decades. Without the Fed's knowledge, it was exceptionally effective at producing the results obtained during that time. That the results were less than optimal is no fault of the operating system, for it performed exactly as programmed by the operators at the time.

Continue to Monetary Policy: Part 3 - The Stable Decades (cont.)