Lessons from a century of FED policy: Why monetary and credit policies need rules and boundaries

Marvin Goodfriend

Journal of Economic Dynamics and Control, 2014, vol. 49, issue C, 112-120

Abstract: Wide operational and financial independence given to monetary and credit policies subjects the Federal Reserve to incentives detrimental for macroeconomic and financial stability. The absence of a monetary policy rule created go-stop incentives that produced inefficient volatility of both inflation and unemployment during the Great Inflation. Fed credit policy has undergone massive “mission creep” since the Fed was established. Being debt-financed fiscal policy, Fed credit policy beyond ordinary temporary lending to solvent depositories creates friction with the fiscal authorities and jeopardizes the Fed׳s independence. An ambiguous boundary of expansive Fed credit policy creates expectations of Fed accommodation in financial crisis—that blunts the incentive of private entities to take protective measures beforehand (to shrink counter-party risk and reliance on short-term finance, and build up equity capital) and blunts the incentive of the fiscal authorities to prepare procedures in advance to act systematically in times of credit turmoil. These points are illustrated with reference to the 2007–09 financial crisis. Part of the problem is that the independent Fed does not have the same incentive as the 19th century Bank of England to follow Bagehot׳s Rule. The paper concludes with a set of principles to preserve a workable, sustainable division of responsibilities between the independent central bank and the fiscal authorities.

Keywords: Bagehot׳s last resort lending rule; Central Bank independence and fiscal policy; Federal Reserve credit policy; Federal Reserve history; Financial crisis of 2007–09; Great Inflation (search for similar items in EconPapers)
JEL-codes: E31 E32 E44 E52 E58 E63 (search for similar items in EconPapers)
Date: 2014
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (18)

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Persistent link: https://EconPapers.repec.org/RePEc:eee:dyncon:v:49:y:2014:i:c:p:112-120

DOI: 10.1016/j.jedc.2014.09.005

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