Federal Reserve Independence: Reality or Myth?

Abstract

The Federal Reserve was founded in 1913 during the Wilson administration to end banking panics and depressions, and was part of the Progressive agenda for a more activist role of government (see Kolko 1963). By the 50th anniversary, the conventional wisdom was that the Fed's performance was overall satisfactory, especially after the Treasury-Federal Reserve Accord of 1951 that permitted independent monetary policy. While the decision to double reserve requirements in 1937 was judged a policy error, the Federal Reserve was not held responsible for the Great Depression. Federal Reserve independence was judged important for optimal monetary policy outcomes. After the end of World War II through 1951, the Federal Reserve was unable to deal with inflation because of the commitment to support government bond rates. By contrast, the central bank pursued a successful monetary policy aimed at price stability in the 1950s after the Accord. The 50th anniversary ironically was the year Milton Friedman and Anna J. Schwartz's monumental A Monetary History of the Federal Reserve: 1867-1960 (Friedman and Schwartz 1963) seriously challenged the conventional wisdom about Fed performance, especially during the Great Depression. (1) By the 1980s, the conventional wisdom of a well-performing central bank came under serious question. Research showed the Fed's restrictive policy in the 1930s contributed to the collapse and stagnation of the economy, while the expansionary policy in the late 1960s through the late 1970s contributed to the Great Inflation. Monetary policy performance after the disinflation of the early 1980s and price stability through the end of the 20th century was viewed in more positive terms. However, easy monetary policy during the run-up in real estate prices from 2001 through 2005 and the unprecedented increase in Federal Reserve assets starting in late 2008 have brought new criticism of Fed performance (see Selgin, Lastrapes, and White 2010; Taylor 2009). Although the belief that the Fed has performed as promised no longer holds sway, the conventional wisdom holds that the Fed is independent, and that independence is important for price stability. The IMF and the OECD place high priority on de jure central bank independence; central bankers emphasize the importance of independence in the conduct of policy (Kohn 2009); references to the importance of independence in news accounts are extensive (Wall Street Journal 2012); and the inverse correlations between measures of central bank independence and inflation are widely accepted and are now becoming standard in textbooks. The conventional wisdom with regard to Fed independence is not convincing. First, the Federal Reserve, considered to be one of the world's more de jure independent central banks, played a key causative role in the Great Inflation from 1965 to 1985. Allan H. Meltzer's history of the Federal Reserve (Meltzer 2003, 2009) demonstrates the sensitivity of the Fed to political institutions despite its de jure independent status. Moreover, the diary of former Fed chairman Arthur F. Burns from 1969 to 1974 (Ferrell 2010) reinforces Meltzer's analysis and presents a challenge to the modern view. Second, the methodological and statistical foundation of the widely accepted inverse correlations between measures of central bank independence and inflation are flawed. The juxtaposition between the historical postwar record of the Federal Reserve and the stable and high indexes of independence assigned to the Federal Reserve are difficult to reconcile. This article argues that Federal Reserve de jure independence is far too uncritically accepted as a foundation for a stable financial and monetary environment. Not only is the foundation weak but its widespread acceptance permits central banks like the Fed to engage in suboptimal policy with political undertones. Independence is more myth than reality. The Misunderstood 1951 Accord The 1951 Accord has generated a misconception about Fed independence and established a misdirected concept of central bank independence in general for decades that emphasized de jure independence. …

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