Ben S Bernanke: A century of US central banking - goals, frameworks,
accountability
Speech by Mr Ben S Bernanke, Chairman of the Board of Governors of the Federal Reserve
System, at "The First 100 Years of the Federal Reserve: The Policy Record, Lessons
Learned, and Prospects for the Future," a conference sponsored by the National Bureau of
Economic Research, Cambridge, Massachusetts, 10 July 2013.
* * *
I'd like to thank the National Bureau of Economic Research for organizing this conference in
recognition of the Federal Reserve's centennial, and I'm glad to have the opportunity to
participate. In keeping with the spirit of the conference, my remarks today will take a
historical perspective. I will leave discussion of current policy to today's question-and-answer
session and, of course, to my congressional testimony next week.
Today, I'll discuss the evolution over the past 100 years of three key aspects of Federal
Reserve policymaking: the goals of policy, the policy framework, and accountability and
communication. The changes over time in these three areas provide a useful perspective, I
believe, on how the role and functioning of the Federal Reserve have changed since its
founding in 1913, as well as some lessons for the present and for the future. I will pay
particular attention to several key episodes of the Fed's history, all of which have been
referred to in various contexts with the adjective "Great" attached to them: the Great
Experiment of the Federal Reserve's founding, the Great Depression, the Great Inflation and
subsequent disinflation, the Great Moderation, and the recent Great Recession.
The Great Experiment
In the words of one of the authors of the Federal Reserve Act, Robert Latham Owen, the
Federal Reserve was established to "provide a means by which periodic panics which shake
the American Republic and do it enormous injury shall be stopped."1 In short, the original goal
of the Great Experiment that was the founding of the Fed was the preservation of financial
stability.2 At the time, the standard view of panics was that they were triggered when the
needs of business and agriculture for liquid funds outstripped the available supply - as when
seasonal plantings or shipments of crops had to be financed, for example - and that panics
were further exacerbated by the incentives of banks and private individuals to hoard liquidity
during such times.3 The new institution was intended to relieve such strains by providing an
"elastic" currency - that is, by providing liquidity as needed to individual member banks
through the discount window; commercial banks, in turn, would then be able to
accommodate their customers. Interestingly, although congressional advocates hoped the
creation of the Fed would help prevent future panics, they did not fully embrace the idea that
the Fed should help end ongoing panics by serving as lender of last resort, as had been
recommended by the British economist and writer Walter Bagehot.4 Legislators imposed
limits on the Federal Reserve's ability to lend in response to panics, for example, by denying
nonmember banks access to the discount window and by restricting the types of collateral
that the Fed could accept.5
The framework that the Federal Reserve employed in its early years to promote financial
stability reflected in large measure the influence of the so-called real bills doctrine, as well as
the fact that the United States was on the gold standard.6 In the framework of the real bills
doctrine, the Federal Reserve saw its function as meeting the needs of business for liquidity
- consistent with the idea of providing an elastic currency - with the ultimate goal of
supporting financial and economic stability.7 When business activity was increasing, the
Federal Reserve helped accommodate the need for credit by supplying liquidity to banks;
when business was contracting and less credit was needed, the Fed reduced the liquidity in
the system.
As I mentioned, the Federal Reserve pursued this approach to policy in the context of the
gold standard. Federal Reserve notes were redeemable in gold on demand, and the Fed was
required to maintain a gold reserve equal to 40 percent of outstanding notes. However,
contrary to the principles of an idealized gold standard, the Federal Reserve often took
actions to prevent inflows and outflows of gold from being fully translated into changes in the
domestic money supply.8 This practice, together with the size of the U.S. economy, gave the
Federal Reserve considerable autonomy in monetary policy and, in particular, allowed the
Fed to conduct policy according to the real bills doctrine without much hindrance.
The policy framework of the Fed's early years has been much criticized in retrospect.
Although the gold standard did not appear to have greatly constrained U.S. monetary policy
in the years after the Fed's founding, subsequent research has highlighted the extent to
which the international gold standard served to destabilize the global economy in the late
1920s and early 1930s.9 Likewise, economic historians have pointed out that, under the real
bills doctrine, the Fed increased the money supply precisely at those times at which business
activity and upward pressures on prices were strongest; that is, monetary policy was
procyclical. Thus, the Fed's actions tended to increase rather than decrease the volatility in
economic activity and prices.10
During this early period, the new central bank did make an important addition to its menu of
policy tools. Initially, the Fed's main tools were the quantity of its lending through the discount
4
See Willis (1923, p. 1407), Carlson and Wheelock (2012), and Bordo and Wheelock (2013). Bagehot ([1873]
1897) is the source of the classic dictum that a panic should be addressed by the central bank, by lending
freely at a penalty rate.
5
The Monetary Control Act of 1980 gave all depository institutions access to the discount window. The
collateral acceptable to be pledged to the discount window has been expanded significantly over time; in
particular, various pieces of banking legislation in the early 1930s enabled the Federal Reserve to make
advances to member banks so long as the loans were "secured to the satisfaction" of the Federal Reserve
Bank extending the loan.
6
See Humphrey (1982) for a discussion of the historical evolution of the real bills doctrine.
7
This interpretation follows from the discussion in the Tenth Annual Report of the Federal Reserve Board
(Board of Governors, 1924). Soon after the Federal Reserve was founded, its mission shifted to supporting the
war effort and then to managing the unwinding of that support. The year 1923 was thus one of the first in
which the Federal Reserve confronted normal peacetime financial conditions, and it took the opportunity to
articulate its views on the appropriate conduct of policy in such conditions.
8
The Federal Reserve could undo the effects of gold inflows on the domestic money supply through open
market operations, discussed later.
9
See, for example, Eichengreen (1992).
10
See Friedman and Schwartz (1963), Humphrey (1982), and Meltzer (2003).
window and the interest rate at which it lent, the discount rate. Early on, however, to
generate earnings to finance its operations, the Federal Reserve began purchasing
government securities in the open market - what came to be known as open market
operations. In the early 1920s, Fed officials discovered that these operations affected the
supply and cost of bank reserves and, consequently, the terms on which banks extended
credit to their customers. Subsequently, of course, open market operations became a
principal monetary policy tool, one that allowed the Fed to interact with the broader financial
markets, not only with banks.11
I've discussed the original mandate and early policy framework of the Fed. What about its
accountability to the public? As this audience knows, when the Federal Reserve was
established, the question of whether it should be a private or a public institution was highly
contentious. The compromise solution created a hybrid Federal Reserve System. The
System was headed by a governmentally appointed Board, which initially included the
Secretary of the Treasury and the Comptroller of the Currency. But the 12 regional Reserve
Banks were placed under a mixture of public and private oversight, including board members
drawn from the private sector, and they were given considerable scope to make policy
decisions that applied to their own Districts. For example, Reserve Banks were permitted to
set their own discount rates, subject to a minimum set by the Board.
While the founders of the Federal Reserve hoped that this new institution would provide
financial and hence economic stability, the policy framework and the institutional structure
would prove inadequate to the challenges the Fed would soon face.
The Great Depression
The Great Depression was the Federal Reserve's most difficult test. Tragically, the Fed failed
to meet its mandate to maintain financial stability. In particular, although the Fed provided
substantial liquidity to the financial system following the 1929 stock market crash, its
response to the subsequent banking panics was limited at best; the widespread bank failures
and the collapse in money and credit that ensued were major sources of the economic
downturn.12 Bagehot's dictum to lend freely at a penalty rate in the face of panic appeared to
have few adherents at the Federal Reserve of that era.13
Economists have also identified a number of instances from the late 1920s to the early 1930s
when Federal Reserve officials, in the face of the sharp economic contraction and financial
upheaval, either tightened monetary policy or chose inaction. Some historians trace these
policy mistakes to the early death of Benjamin Strong, governor of the Federal Reserve Bank
of New York, in 1928, which left the decentralized system without an effective leader.14
Whether valid or not, this hypothesis raises the interesting question of what intellectual
framework an effective leader would have drawn on at the time to develop and justify a more
activist monetary policy. The degree to which the gold standard actually constrained U.S.
monetary policy during the early 1930s is debated; but the gold standard philosophy clearly
did not encourage the sort of highly expansionary policies that were needed.15 The same can
be said for the real bills doctrine, which apparently led policymakers to conclude, on the
basis of low nominal interest rates and low borrowings from the Fed, that monetary policy
was appropriately supportive and that further actions would be fruitless.16 Historians have
also noted the prevalence at the time of yet another counterproductive doctrine: the so-called
liquidationist view, that depressions perform a necessary cleansing function.17 It may be that
the Federal Reserve suffered less from lack of leadership in the 1930s than from the lack of
an intellectual framework for understanding what was happening and what needed to be
done.
The Fed's inadequate policy frameworks ultimately collapsed under the weight of economic
failures, new ideas, and political developments. The international gold standard was
abandoned during the 1930s. The real bills doctrine likewise lost prestige after the disaster of
the 1930s; for example, the Banking Act of 1935 instructed the Federal Reserve to use open
market operations with consideration of "the general credit situation of the country," not just
to focus narrowly on short-term liquidity needs.18 The Congress also expanded the Fed's
ability to provide credit through the discount window, allowing loans to a broader array of
counterparties, secured by a broader variety of collateral.19
The experience of the Great Depression had major ramifications for all three aspects of the
Federal Reserve I am discussing here: its goals, its policy framework, and its accountability
to the public. With respect to goals, the high unemployment of the Depression - and the fear
that high unemployment would return after World War II - elevated the maintenance of full
employment as a goal of macroeconomic policy. The Employment Act of 1946 made the
promotion of employment a general objective for the federal government. Although the Fed
did not have a formal employment goal until the Federal Reserve Reform Act of 1977
codified "maximum employment," along with "stable prices," as part of the Fed's so-called
dual mandate, earlier legislation nudged the central bank in that direction.20 For example,
legislators described the intent of the Banking Act of 1935 as follows: "To increase the ability
of the banking system to promote stability of employment and business, insofar as this is
possible within the scope of monetary action and credit administration."21
The policy framework to support this new approach reflected the development of
macroeconomic theories - including the work of Knut Wicksell, Irving Fisher, Ralph Hawtrey,
Dennis Robertson, and John Maynard Keynes - that laid the foundations for understanding
how monetary policy could affect real activity and employment and help reduce cyclical
fluctuations. At the same time, the Federal Reserve became less focused on its original
mandate of preserving financial stability, perhaps in part because it felt superseded by the
creation during the 1930s of the Federal Deposit Insurance Corporation and the Securities
and Exchange Commission, along with other reforms intended to make the financial system
more stable.
16
See Meltzer (2003) and Romer and Romer (2013).
17
See, for example, DeLong (1990).
18
This language amended section 12A(c) of the Federal Reserve Act.
19
For example, section 10B enhanced the powers of the Federal Reserve to lend to member banks, and
sections 13(3) and 13(13) enabled the Federal Reserve to provide short-term credit to a wide range of
potential borrowers in specific circumstances.
20
More precisely, the three statutory objectives for monetary policy set forth in the Federal Reserve Reform Act
of 1977 are maximum employment, stable prices, and moderate long-term interest rates. The dual mandate
refers to the first two goals, and the long-term interest rate goal is viewed as likely to emerge from the
macroeconomic environment associated with achievement of the employment and price stability goals
(Mishkin, 2007). Thus, the interest rate goal of the Federal Reserve Reform Act can be regarded as subsumed
within the dual mandate.
21
See U.S. Congress (1935).
In the area of governance and accountability to the public, policymakers also recognized the
need for reforms to improve the Federal Reserve's structure and decisionmaking. The
Banking Act of 1935 simultaneously bolstered the legal independence of the Federal
Reserve and provided for stronger central control by the Federal Reserve Board. In
particular, the act created the modern configuration of the Federal Open Market Committee
(FOMC), giving the Board the majority of votes on the Committee, while removing the
Secretary of the Treasury and the Comptroller of the Currency from the Board. In practice,
however, the Treasury continued to have considerable sway over monetary policy after 1933,
with one economic historian describing the Fed as "in the back seat."22 During World War II,
the Federal Reserve used its tools to support the war financing efforts. However, even after
the war, Federal Reserve policy remained subject to considerable Treasury influence. It was
not until the 1951 Accord with the Treasury that the Federal Reserve began to recover
genuine independence in setting monetary policy.
The Great Inflation and Disinflation
Once the Federal Reserve regained its policy independence, its goals centered on the price
stability and employment objectives laid out in the Employment Act of 1946. In the early
postwar decades, the Fed used open market operations and the discount rate to influence
short-term market interest rates, and the federal funds rate gradually emerged as the
preferred operating target. Low and stable inflation was achieved for most of the 1950s and
the early 1960s. However, beginning in the mid-1960s, inflation began a long climb upward,
partly because policymakers proved to be too optimistic about the economy's ability to
sustain rapid growth without inflation.23
Two mechanisms might have mitigated the damage from that mistaken optimism. First, a
stronger policy response to inflation - more like that observed in the 1950s - certainly would
have helped.24 Second, Fed policymakers could have reacted to continued high readings on
inflation by adopting a more realistic assessment of the economy's productive potential.25
Instead, policymakers chose to emphasize so-called cost-push and structural factors as
sources of inflation and saw wage- and price-setting as having become insensitive to
economic slack.26 This perspective, which contrasted sharply with Milton Friedman's famous
dictum that "inflation is always and everywhere a monetary phenomenon," led to Fed support
for measures such as wage and price controls rather than monetary solutions to address
inflation.27 A further obstacle was the view among many economists that the gains from low
inflation did not justify the costs of achieving it.28
The consequence of the monetary framework of the 1970s was two bouts of double-digit
inflation. Moreover, by the end of the decade, lack of commitment to controlling inflation had
clearly resulted in inflation expectations becoming "unanchored," with high estimates of trend
inflation embedded in longer-term interest rates.
As you know, under the leadership of Chairman Paul Volcker, the Federal Reserve in 1979
fundamentally changed its approach to the issue of ensuring price stability. This change
involved an important rethinking on the part of policymakers. By the end of the 1970s,
Federal Reserve officials increasingly accepted the view that inflation is a monetary
phenomenon, at least in the medium and longer term; they became more alert to the risks of
excessive optimism about the economy's potential output; and they placed renewed
emphasis on the distinction between real - that is, inflation-adjusted - and nominal interest
rates.29 The change in policy framework was initially tied to a change in operating procedures
that put greater focus on growth in bank reserves, but the critical change - the willingness to
respond more vigorously to inflation - endured even after the Federal Reserve resumed its
traditional use of the federal funds rate as the policy instrument.30 The new regime also
reflected an improved understanding of the importance of providing a firm anchor, secured
by the credibility of the central bank, for the private sector's inflation expectations.31 Finally, it
entailed a changed view about the dual mandate, in which policymakers regarded
achievement of price stability as helping to provide the conditions necessary for sustained
maximum employment.32
The Great Moderation
Volcker's successful battle against inflation set the stage for the so-called Great Moderation
of 1984 to 2007, during which the Fed enjoyed considerable success in achieving both
objectives of its dual mandate. Financial stability remained a goal, of course. The Federal
Reserve monitored threats to financial stability and responded when the financial system was
upset by events such as the 1987 stock market crash and the terrorist attacks of 2001. More
routinely, it shared supervisory duties with other banking agencies. Nevertheless, for the
most part, financial stability did not figure prominently in monetary policy discussions during
these years. In retrospect, it is clear that macroeconomists - both inside and outside central
banks - relied too heavily during that period on variants of the so-called Modigliani-Miller
theorem, an implication of which is that the details of the structure of the financial system can
be ignored when analyzing the behavior of the broader economy.
An important development of the Great Moderation was the increasing emphasis that central
banks around the world put on communication and transparency, as economists and
policymakers reached consensus on the value of communication in attaining monetary policy
objectives.33 Federal Reserve officials, like those at other central banks, had traditionally
been highly guarded in their public pronouncements. They believed, for example, that the
ability to take markets by surprise was important for influencing financial conditions.34 Thus,
although Fed policymakers of the 1980s and early 1990s had become somewhat more
explicit about policy objectives and strategy, the same degree of transparency was not
29
For discussion of these points, see Meltzer (2009b).
30
See, for example, Axilrod (1982).
31
Central banks' emphasis on expectations management partly reflected lessons from the rational expectations
literature of the 1970s. Monetary policy implications of the rational expectations literature were further clarified
by later research. For example, Sargent (1982) brought out dramatically the dependence of inflation
expectations on the monetary policy regime in his study of major disinflations, while rational expectations
models were extended to include sticky prices (Fischer, 1977; Taylor, 1980; Rotemberg, 1982; Calvo, 1983)
and interest rate rules (Sargent and Wallace, 1975; McCallum, 1981; Taylor, 1993, 1999b; Woodford, 2003).
32
See Lindsey, Orphanides, and Rasche (2005).
33
See Woodford (2005). Many of these principles were codified in the emerging doctrine of inflation targeting,
the practice of which was greatly advanced by central banks in other countries. One of the most notable
examples is New Zealand's introduction of inflation targeting in 1990.
34
See, for example, Goodfriend (1986) and Cukierman and Meltzer (1986).
forthcoming on monetary policy decisions and operations.35 The release of a postmeeting
statement by the FOMC, a practice that began in 1994, was, therefore, an important
watershed. Over time, the statement was expanded to include more detailed information
about the reason for the policy decision and an indication of the balance of risks.36
In addition to improving the effectiveness of monetary policy, these developments in
communications also enhanced the public accountability of the Federal Reserve.
Accountability is, of course, essential for policy independence in a democracy. During this
period, economists found considerable evidence that central banks that are afforded policy
independence in the pursuit of their mandated objectives deliver better economic
outcomes.37
One cannot look back at the Great Moderation today without asking whether the sustained
economic stability of the period somehow promoted the excessive risk-taking that followed.
The idea that this long period of calm lulled investors, financial firms, and financial regulators
into paying insufficient attention to building risks must have some truth in it. I don't think we
should conclude, though, that we therefore should not strive to achieve economic stability.
Rather, the right conclusion is that, even in (or perhaps, especially in) stable and prosperous
times, monetary policymakers and financial regulators should regard safeguarding financial
stability to be of equal importance as - indeed, a necessary prerequisite for - maintaining
macroeconomic stability.
Macroeconomists and historians will continue to debate the sources of the remarkable
economic performance during the Great Moderation.38 My own view is that the improvements
in the monetary policy framework and in monetary policy communication, including, of
course, the better management of inflation and the anchoring of inflation expectations, were
important reasons for that strong performance. However, we have learned in recent years
that while well-managed monetary policy may be necessary for economic stability, it is not
sufficient.
The financial crisis, the Great Recession, and today
It has been about six years since the first signs of the financial crisis appeared in the United
States, and we are still working to achieve a full recovery from its effects. What lessons
should we take for the future from this experience, particularly in the context of a century of
Federal Reserve history?
The financial crisis and the ensuing Great Recession reminded us of a lesson that we
learned both in the 19th century and during the Depression but had forgotten to some extent,
which is that severe financial instability can do grave damage to the broader economy. The
implication is that a central bank must take into account risks to financial stability if it is to
help achieve good macroeconomic performance. Today, the Federal Reserve sees its
responsibilities for the maintenance of financial stability as coequal with its responsibilities for
the management of monetary policy, and we have made substantial institutional changes in
recognition of this change in goals. In a sense, we have come full circle, back to the original
goal of the Federal Reserve of preventing financial panics.39
How should a central bank enhance financial stability? One means is by assuming the
lender-of-last-resort function that Bagehot understood and described 140 years ago, under
which the central bank uses its power to provide liquidity to ease market conditions during
periods of panic or incipient panic. The Fed's many liquidity programs played a central role in
containing the crisis of 2008 to 2009. However, putting out the fire is not enough; it is also
important to foster a financial system that is sufficiently resilient to withstand large financial
shocks. Toward that end, the Federal Reserve, together with other regulatory agencies and
the Financial Stability Oversight Council, is actively engaged in monitoring financial
developments and working to strengthen financial institutions and markets. The reliance on
stronger regulation is informed by the success of New Deal regulatory reforms, but current
reform efforts go even further by working to identify and defuse risks not only to individual
firms but to the financial system as a whole, an approach known as macroprudential
regulation.
Financial stability is also linked to monetary policy, though these links are not yet fully
understood. Here the Fed's evolving strategy is to make monitoring, supervision, and
regulation the first line of defense against systemic risks; to the extent that risks remain,
however, the FOMC strives to incorporate these risks in the cost-benefit analysis applied to
all monetary policy actions.40
What about the monetary policy framework? In general, the Federal Reserve's policy
framework inherits many of the elements put in place during the Great Moderation. These
features include the emphasis on preserving the Fed's inflation credibility, which is critical for
anchoring inflation expectations, and a balanced approach in pursuing both parts of the
Fed's dual mandate in the medium term. We have also continued to increase the
transparency of monetary policy. For example, the Committee's communications framework
now includes a statement of its longer-run goals and monetary policy strategy.41 In that
statement, the Committee indicated that it judged that inflation at a rate of 2 percent (as
measured by the annual change in the price index for personal consumption expenditures) is
most consistent over the longer run with the FOMC's dual mandate. FOMC participants also
regularly provide estimates of the longer-run normal rate of unemployment; those estimates
currently have a central tendency of 5.2 to 6.0 percent. By helping to anchor longer-term
expectations, this transparency gives the Federal Reserve greater flexibility to respond to
short-run developments. This framework, which combines short-run policy flexibility with the
discipline provided by the announced targets, has been described as constrained
discretion.42 Other communication innovations include early publication of the minutes of
FOMC meetings and quarterly postmeeting press conferences by the Chairman.
The framework for implementing monetary policy has evolved further in recent years,
reflecting both advances in economic thinking and a changing policy environment. Notably,
following the ideas of Lars Svensson and others, the FOMC has moved toward a framework
that ties policy settings more directly to the economic outlook, a so-called forecast-based
approach.43 In particular, the FOMC has released more detailed statements following its
meetings that have related the outlook for policy to prospective economic developments and
has introduced regular summaries of the individual economic projections of FOMC
participants (including for the target federal funds rate). The provision of additional
information about policy plans has helped Fed policymakers deal with the constraint posed
by the effective lower bound on short-term interest rates; in particular, by offering guidance
about how policy will respond to economic developments, the Committee has been able to
increase policy accommodation, even when the short-term interest rate is near zero and
cannot be meaningfully reduced further.44 The Committee has also sought to influence
interest rates further out on the yield curve, notably through its securities purchases. Other
central banks in advanced economies, also confronted with the effective lower bound on
short-term interest rates, have taken similar measures.
In short, the recent crisis has underscored the need both to strengthen our monetary policy
and financial stability frameworks and to better integrate the two. We have made progress on
both counts, but more needs to be done. In particular, the complementarities among
regulatory and supervisory policies (including macroprudential policy), lender-of-last-resort
policy, and standard monetary policy are increasingly evident. Both research and experience
are needed to help the Fed and other central banks develop comprehensive frameworks that
incorporate all of these elements. The broader conclusion is what might be described as the
overriding lesson of the Federal Reserve's history: that central banking doctrine and practice
are never static. We and other central banks around the world will have to continue to work
hard to adapt to events, new ideas, and changes in the economic and financial environment.
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