post-war Fed

The Fed & Big Banking at the Crossroads by Paul Volcker

I have been struck by parallels between the challenges facing the Federal Reserve today and those when I first entered the Federal Reserve System as a neophyte economist in 1949.

Most striking then, as now, was the commitment of the Federal Reserve, which was and is a formally independent body, to maintaining a pattern of very low interest rates, ranging from near zero to 2.5 percent or less for Treasury bonds. If you feel a bit impatient about the prevailing rates, quite understandably so, recall that the earlier episode lasted fifteen years.

The initial steps taken in the midst of the depression of the 1930s to support the economy by keeping interest rates low were made at the Fed’s initiative. The pattern was held through World War II in explicit agreement with the Treasury. Then it persisted right in the  face of double-digit inflation after the war, increasingly under Treasury and presidential pressure to keep rates low.

The growing restiveness of the Federal Reserve was reflected in testimony by Marriner Eccles in 1948:

"Under the circumstances that now exist the Federal Reserve System is the greatest potential agent of inflation that man could possibly contrive."

This was pretty strong language by a sitting Fed governor and a long-serving board chairman. But it was then a fact that there were many doubts about whether the formality of the independent legal status of the central bank—guaranteed since it was created in 1913—could or should be sustained against Treasury and presidential importuning. At the time, the influential Hoover Commission on government reorganization itself expressed strong doubts about the Fed’s independence. In these years calls for freeing the market and letting the Fed’s interest rates rise met strong resistance from the government.

Treasury debt had enormously increased during World War II, exceeding 100 percent of the GDP, so there was concern about an intolerable impact on the budget if interest rates rose strongly. Moreover, if the Fed permitted higher interest rates this might lead to panicky and speculative reactions. Declines in bond prices, which would fall as interest rates rose, would drain bank capital. Main-line economists, and the Fed itself, worried that a sudden rise in interest rates could put the economy back in recession.

All of those concerns are in play today, some sixty years later, even if few now take the extreme view of the first report of the then new Council of Economic Advisers in 1948: “low interest rates at all times and under all conditions, even during inflation,” it said, would be desirable to promote investment and economic progress. Not exactly a robust defense of the Federal Reserve and independent monetary policy.

Eventually, the Federal Reserve did get restless, and finally in 1951 it rejected overt presidential pressure to maintain a ceiling on long-term Treasury rates. In the event, the ending of that ceiling, called the “peg,” was not dramatic. Interest rates did rise over time, but with markets habituated for years to a low interest rate, the price of long-term bonds remained at moderate levels. Monetary policy, free to act against incipient inflationary tendencies, contributed to fifteen years of stability in prices, accompanied by strong economic growth and high employment. The recessions were short and mild.

(Emphasis added.) "Short and mild" unlike Vocker's recession. His "exit strategy" was overrated.  Didn't the double-digit inflation/financial repression help with deleveraging. Many economists at the time like Paul Samuelson expected the economy to return to Depression after the war.