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An insider's account of the workings of the Federal Reserve, thoroughly updated to encompass the Fed's action (and inaction) during the recent financial meltdown.
Stephen Axilrod is the ultimate Federal Reserve insider. He worked at the Fed's Board of Governors for more than thirty years and after that in private markets and as a consultant on monetary policy. With Inside the Fed, he offers his unique perspective on the inner workings of the Federal Reserve System during the last fifty years. This new, post-financial meltdown edition offers his assessment of the Fed's action (and inaction) during the crisis and expanded coverage of the Fed in the Bernanke era.
Great leadership in monetary policy, Axilrod says, is determined not by pure economic sophistication but by the ability to push through political and social barriers to achieve a paradigm shift in policy and by the courage and bureaucratic moxie to pull it off.
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About the Author
Stephen H. Axilrod worked from 1952 to 1986 at the Board of Governors of the Federal Reserve System in Washington, D.C., rising to Staff Director for Monetary and Financial Policy and Staff Director and Secretary of the Federal Open Market Committee, the Fed's main monetary policy arm. Since 1986 he has worked in private markets and as a consultant on monetary policy with foreign monetary authorities. He is the author of The Federal Reserve: What Everyone Needs to Know.
Read an Excerpt
Inside the FedMonetary Policy and Its Management, Martin through Greenspan to Bernanke
By Stephen H. Axilrod
The MIT PressCopyright © 2009 Massachusetts Institute of Technology
All right reserved.
Chapter OneOverview of Policy Management and Managers
If you believe the national media, the head of our nation's central bank-the chairman of the Board of Governors of the Federal Reserve System-is thought to be the second most important person in the country. This position carried no such status in the early 1950s when I first reported for work through the C Street entrance of the Fed's headquarters building in Washington, D.C., a white marble, rectangular, faintly classical structure that fronted Constitution Avenue and, across the road, the extensive green mall with its affecting monuments to the nation's history.
At that time, monetary policy was very far from a national watchword, and markets were far from being obsessed by the Federal Reserve System's actions. A few economists thought the Fed was important. Some, especially those often termed monetarists, even had the temerity to blame it for conditions leading to the stock-market crash of 1929 and the ensuing economic depression, for the economy's extended failure to recover, and for the secondary recession in 1937-1938, when the Fed took action that arguably cut short a promising revival in economic activity.
By and large, the Fed escaped being closely and causally linked with the deep and lasting depression of the 1930s by the press, the public, and the political world. Instead, errors in the conduct of the nation's fiscal policy came more into focus. As the story went, the need for enlarged government spending to revive the economy during this dreadful, long economic slump was not understood at the time either by politicians or by fiscal experts, many then prominent in academia, so the economy did not escape from its doldrums until spending was literally forced upon us by the coming of World War II.
This explanation, although far from complete, does have much validity. It is what I internalized from my studies as an undergraduate at Harvard College. After the war, with GI Bill in hand (and some parental supplement), I had transferred there from Southern Methodist University in Dallas, where my family had moved in the middle of the Depression when I was going on eleven years old.
Not until the great inflation that began in the mid-1960s in the United States and lasted about fifteen years did the Fed's central role in the economy become clearly and perhaps irrevocably impressed on public consciousness. The persistent, detailed research and broad educational efforts of modern-day monetarists such as Milton Friedman and others were in part responsible for helping to convince the U.S. Congress and the public of the Fed's crucial role in permitting, if not originating, the inflation. Because the Fed was the sole institution in the country with the power, as it were, to create money, and because everyone readily understood that too much money chasing too few goods caused inflation, the Fed's influence and responsibility were quite evident.
During a depression, the Fed or any other central bank can often hide its responsibility for continued economic weakness behind the old saw that "you can lead a horse to water, but you can't make it drink." Central bankers can and do in effect say, "Don't blame us if people won't borrow enough or use enough of their cash to spend and get the country out of a depression." Although that position is not a terribly unreasonable one to take, it does not really get the central bank off the hook because it begs the question of how the nation gets into such a position in the first place and what the central bank's responsibility is for getting it there.
In any event, the idea that the Fed's chairman is the second most important person in the country increasingly took root in the public's understanding, insofar as I can judge, when inflation was finally suppressed in the early 1980s by an aggressive counterinflationary policy under Chairman Volcker. And such a view of the Fed chairman remained in place under Greenspan.
Volcker and Greenspan's immediate predecessors, Arthur Burns and Bill Miller, presided over a Fed that failed to control inflation, and the country was quite sensibly reluctant to bestow a complimentary sobriquet on leaders who were not performing well, certainly not as well as they should. Neither of these two chairmen acquired the kind of credibility and prestige associated with successful policies that would make private market participants hang breathlessly on their every word.
In the last analysis, the immense power of monetary policy resides, of course, not in the individual chairmen, but in the institution of the Fed itself. Chairmen become powerful to the extent they can influence the votes of their policymaking colleagues. A chairman's influence is generally more limited than one might in the abstract expect. It waxes and wanes with the chairman's particular skills and charisma in the internal management of policy, as well as with his own credibility with the public and Congress, which in turn strongly affects his internal credibility. Nevertheless, a chairman can have an outsized impact on policy, especially at crucial times, if he has sufficient nerve, internal credibility, and a kind of unique, "artistic" feel to see and take advantage of the potential for increased policy maneuverability within a constellation of economic, social, and political forces.
The Federal Reserve Act, originally enacted in 1913 and amended frequently over the years in response to changing economic and financial circumstances and experience, established the central bank that the chairman leads. As many readers may well know, the Fed comprises the Board of Governors in Washington and twelve Federal Reserve Banks headquartered in cities around the country to provide central-bank services for their regions, such as clearings and payments in connection with monies flowing through bank deposit accounts. Although this regional structure appears a bit anachronistic by now as the rapid and revolutionary advances in financial technology of recent decades, among other things, have further eroded the role of purely regional payments and banking systems, it does continue to serve as an important channel for engaging the country as a whole in the formation and understanding of monetary policy through the participation of the Reserve Banks in the policy process.
The president of the United States appoints the chairman of the Board of Governors of the Federal Reserve System and the other six board members with the Senate's consent. A board member's term is fourteen years, and one term expires on January 31 of each even-numbered year. The chairman and vice chairman have four-year terms, and since 1977 the two are also subject to approval by the Senate. But once that approval is given, the executive branch plays no role at all in the Fed's domestic monetary policy decisions-thus the Fed's independence.
Monetary policy is basically set in the FOMC, a body established by the Federal Reserve Act to govern the system's operations in the market for U.S. government securities and certain other instruments. The committee is composed of twelve voting members, including all seven board members, the president of the Federal Reserve Bank of New York (New York Fed), and four of the eleven other Reserve Bank presidents, who serve in rotation.
Oddly enough, the law leaves it up to the FOMC to determine its own leadership structure. By long tradition, the chairman of the Fed Board of Governors is annually elected to serve also as chairman of the FOMC, and the president of the New York Fed is elected as vice chairman of that body. I always sensed a certain amount of tension in the room when the vote was to be taken on the FOMC's leadership structure, including its official staff, as needs to be done once a year because a change in membership takes place annually.
The Fed is essentially a creature of the Congress and responsible to that arm of government. As a result, the most important national political figures for the Fed are the chairmen of the House and Senate committees that deal with banking and central banking. The president clearly is secondary in importance for the Fed, and the Congress is extremely sensitive to any hints that he might be seeking or that the Fed might be ceding to him any role as an influence on the central bank's decision-making responsibilities, the principal ones being in the area of monetary policy.
When accompanying a Fed chairman to congressional hearings, as I often did when monetary policy was up for discussion, I would, on an occasion or two, hear a senator or representative ask the chairman how frequently he met with the president. I had the distinct impression that the less contact the better, especially if the questioner was in the opposite party from the sitting president. The amount of contact was, so far as I could tell, rather modest, though it varied with conditions of the time and with the interest and attitudes of individual presidential officeholders. The dreary technicalities of monetary policy were certainly of no interest to presidents, and any such discussions were left to other interactions.
With the chairman at its helm, exerting more or less influence depending on his credibility and talents, the Fed as an institution independently makes monetary policy decisions that are crucial to the macroeconomy's behavior in regard to inflation, the ups and downs of economic activity, interest rates, and the financial system's stability. But its independence is obviously far from absolute. Bill Martin, the Fed chairman when I first arrived, used to say (whether original to him I do not know) that the Fed was independent within the government, a formulation that has often been repeated. The phrase's practical meaning is not easy to discern, but it is evocative and somehow reassuring. One reasonable interpretation is that the Fed, like the other elements of government in a democratic country, chooses policies from a broad range of options that are or through further explanation can be made generally acceptable to the country as a whole, recognizing that disagreements of more or less intensity can hardly ever be avoided.
Apart from any particular interpretation, the phrase itself stood me in good stead several years ago in Indonesia during a discussion with one of that country's many and apparently ubiquitous former finance ministers-this particular one, at the time, a very influential informal adviser to a new Indonesian "reform" president coming to office following Suharto's downfall. The country's legislature was then in process of enacting a law that would give the nation's central bank more independence. As a way of helping to explain what might be involved in this process to a gentleman who seemed to have some doubts about the law's wisdom, I used the Martin phrase "independent within the government." It was as if a bulb lit up in his mind, and he reiterated my words and added, in reassuring himself, "not independent from the government."
I made no effort to discuss the issue further, thinking it best to let unspoken differences of interpretation remain submerged. Given the political situation in Indonesia, which was still in a state of transition from a dictatorship to a more democratic form of government, and the historically delicate relationships between the Indonesian central bank and the Ministry of Finance, it seemed best at the time to refrain from further efforts to explore the exact meaning of "independence." It was a good bet that our views of what it meant to be "independent within, but not independent from the government" would, as a practical matter, turn out to be different-no doubt as such independence related to the degree, frequency, and effectiveness of influence that the political authorities could be expected to bring to bear on the central bank's decision-making processes.
Although the Fed's legislated independence helps shelter its decision making from interference by the administration, the decisions themselves are inevitably subject to certain constraints. The instruments of monetary policy are generally powerful and far-reaching enough to keep inflation under control and the macroeconomy on a fairly even keel over a reasonable period of time. But in some extreme economic circumstances-such as those that might be and often have been associated with very large oil-price shocks, wars, financial collapses, highly irresponsible fiscal policies, and other similar forces that are largely exogenous to policy-the effective deployment of monetary powers raises serious political issues for the central bank. For instance, the bank's powers may not be deployable in a way that keeps both economic growth and the rate of inflation within acceptable bounds, at least for a while (sometimes a rather long while).
In such circumstances, Fed policymakers, being very well aware that they are part of a government established to be democratically representative of the people, are themselves likely to be constrained in the policies that they find it practical to consider by their sense of what is tolerable to the country. Of course, they may be right or they may be wrong in their judgment of the country's attitudes. Or they may fail to understand the degree to which they, through convincing argumentation, can affect public attitudes and enlarge the scope for monetary policy actions. However that may be, I am convinced that such judgments, or perhaps such feelings, whether expressed (essentially they are not) or recognized, lie deep within the individual policymaker's gut. The policymakers are independent, but they are making decisions from within the government and within what they perceive to be certain societal bounds.
The impact of such virtually unavoidable covert judgments surfaced, for example, in the 1970s when the Fed, in the wake of huge oil-price increases, accepted a sizeable inflation rather than risk the possibility of a deep and unduly lasting recession that may have been required to fight inflation even harder and more effectively in the circumstances of the period. The stars reflective of current economic conditions and of political and social attitudes were simply not in proper alignment-or at least leadership at the time could not discern them.
The stars were in better alignment toward the end of that decade and in the early 1980s after it became clear that inflation was itself harmful to growth and to the country's overall well-being. Evolving changes in financial-market structure had also helped level the economic/ political playing field. For instance, because of market innovations, small savers were becoming increasingly able to benefit from the high interest rates that were temporarily involved in the fight against inflation. This benefit served to counter pressure on the Fed from powerful congressional support for the agricultural, small business, and home borrowers who were hurt by the higher rates. In brief, the contextual cost-benefit calculus for policymakers became more socially and politically balanced.
Within such a broad understanding of what it means to be independent, the Fed over the past half-century has often, and with varying degrees of success, altered the process by which it formulates, implements, and explicates monetary policy. The exact nature of these adaptations has been influenced by the growth in knowledge about economics as gained from the Fed's own experience and from academic research (both inside and outside the institution), by a changing political and social environment, and by ongoing structural changes in the nation's banking and financial system. Particularly as seen from the inside, the evolution in the policy process has also involved power dynamics within the Fed's own bureaucratic processes, including very importantly the temperament, experience, and leadership capabilities of the various chairmen.
With regard to macroeconomic stability, inflation is, of course, a major concern of a nation's central bank. Some would say it should be the only concern, but it is certainly not the only concern in the United States. I doubt it is ever quite the only concern anywhere in the world, no matter how statutes are written or what public statements the central bank may issue. No central bank can simply ignore what is happening to other aspects of the macroeconomy, such as unemployment, growth, and financial stability.
In any event, for the United States, the monetary policy objectives as stated in the Federal Reserve Act (as modified in November 1977 and retained since) require the Fed to "maintain long run growth of the monetary and credit aggregates ... so as to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates." In the real world, the counterparts to these objectives have changed over the years as both the Fed and the public have become more economically and financially sophisticated, helped along not only by advances in economics research, but also, perhaps more especially, by the cold bath of actual experience. Nonetheless, the potential for conflicts among objectives remains.
The principal area for conflict in practice centers on two crucial objectives: maximum employment and stable prices. Especially in the short term, these two objectives often seem to run up against each other, and the Fed in practice is always adjusting its short-term policy stance in an attempt to reconcile them. At one extreme, when inflation threatens, the Fed attempts to keep the economy from weakening unduly when it has to restrain upward price pressures by doing what it can to force businesses and consumers to hold back on their spending for goods and services. At the other extreme, when the economy is slack, the Fed attempts to avoid arousing inflationary forces that may be dormant in a slack economy while doing what it can to encourage spending on goods and services and hence economic growth.
Excerpted from Inside the Fed by Stephen H. Axilrod Copyright © 2009 by Massachusetts Institute of Technology. Excerpted by permission.
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Table of Contents
1 Overview of Policy Management and Managers....................5
2 In Bill Martin's Time....................23
3 Arthur Burns and the Struggle against Inflation....................55
4 The Miller Interlude....................79
5 Paul Volcker and the Victory over Inflation....................91
6 The Greenspan Years and After....................123
7 The Fed and Its Image....................159
8 Summing Up and Looking Ahead....................173
Most Helpful Customer Reviews
The Fed has been more than free in making policies without informed oversight. These policies have so much impact on the market and economy as a whole that a group of knowledgeable citizens should report regularly.