An Episodic History of Modern Fed Independence

By Smith, Daniel J.; Boettke, Peter J. | Independent Review, Summer 2015 | Go to article overview

An Episodic History of Modern Fed Independence


Smith, Daniel J., Boettke, Peter J., Independent Review


The Congress established the Federal Reserve, set its monetary policy objectives, and provided it with operational independence to pursue those objectives. The Federal Reserve's operational independence is critical, as it allows the [Federal Open Market Committee] to make monetary policy decisions based solely on the longer-term needs of the economy, not in response to short-term political pressures.

-Ben S. Bernanke, Semiannual Monetary Policy Report to the Congress (2011)

This paper contextualizes, supports, and informs previous empirical studies on the independence of the Federal Reserve (Fed) with an episodic history of modern Fed independence. At the Fed's founding, its independence was considered necessary to separate monetary policy from the influence of electorally focused politicians and special-interest groups (Kettl 1986, 3; Morris 2002, 4-5; Bernanke 2010a). According to C. W. Barron, at its founding, Fed independence meant that "[i]f the new Federal Reserve Board is of the desired quality and character it will be the most unpopular board that ever sat in Washington. It will turn deaf ears to all political and sectional considerations. The greater the clamor for cheap money the tighter it will hold the reserves" (1914, 13).

With these concerns in mind, the structure of the Fed was designed to turn "monetary policy over to a small group of people selected so as to balance the interests for and against inflation" (Faust 1996, 268). Although the Fed is an agency of Congress and responsible to Congress, the need for an independent Fed to "make monetary policy independently of short-term political influence" (Bernanke 2010a) has been recognized since the Fed's inception.

Despite early efforts to create an independent Fed, its independence was quickly undermined during the tumultuous political and economic periods of World War I, the Great Depression, and World War II (Havrilesky 1995b; Meitzer 2003). Some economists hold that structural tweaks and greater transparency have ensured, according to Ben Bernanke, that the "effective degree of independence [at the Fed] has gradually increased over time" (2010a). However, empirical studies measuring the degree of Fed independence have found, even in modern times, evidence of substantially compromised Fed independence (Boettke and Smith 2013).

This paper seeks to understand how the modern Fed, despite the many steps taken since its founding to ensure independence, still succumbs to political influence. We examine the postwar period to focus on the modern Fed's independence following the 1951 Accord between the U.S. Department of the Treasury and the Fed, which, according to Robert Hetzel and Ralph Leach, "marked the start of the modern Federal Reserve System" (2001b, 53-54). Michael Munger and Brian Roberts also indicate that following the 1951 Accord the Fed had a mandate to "lean against the wind, implying an unprecedented discretionary choice of how much monetary growth was too much, and how little was too little" (1993, 90). Our episodic history finds that even an increasingly sheltered Fed, primarily under the control of economists with increasingly refined monetary models, has failed to remain independent of political pressures. Although the Fed has at times been able to assert its independence, it is clear that at times it has also succumbed to political pressure.

We use an anecdotal approach to supplement the existing empirical approaches because, as David Meiselman argues, "« convincing test or proof may require more detailed and explicit information about explicit intentions on a more micro level, including who said and did what to whom" (1986, 571, emphasis in original) and, as Kevin Grier stresses, "No amount of regression analysis can ever prove that the Fed is politically controlled" (1987, 481; see also Grier 1989, 388). Historical context is necessary to supplement the existing empirical investigations to understand when these separate influences were operational and the mechanism of their operation. …

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