The current regime of extreme monetary policy that has become the new normal - to which we have become entirely desensitized and addicted - remains the biggest (and most dangerous) experiment in central planning in the 100 year history of the Fed. Trusting the beard and his band of PhDs to get this right may be a stretch though, as UBS' Art Cashin notes, their track record has not been stellar and as he notes from the 10th Annual Report of the Fed: "the Fed was supposed to extend credit only for 'productive' and not for 'speculative' purposes."
UBS' Art Cashin,
100 Years Of Trial And Error And Error At The Fed
Yesterday, we alluded to trading floor buzz about a research paper by Julio Rotemberg, titled "Penitence after accusations of error: 100 Years of Monetary Policy at the U.S. Federal Reserve". We noted it was one of a series of papers presented at an NBER symposium on “The First Hundred Years of the Federal Reserve: The Policy Record, Lessons Learned, and Prospects for the Future”.
While Mr. Rotemberg's opus is primarily directed at academics, it does provide insights about how the Fed stumbled through the evolution of central banking in the U.S.
One of its earliest concerns after its founding was to prevent inflation from exploding after World War I as many had expected. Other than that it saw its purpose as aiding only solid normal growth in the economy. As Rotemberg notes "The Tenth Annual Report of the Federal Reserve Board said that the Fed was supposed to extend credit only for “productive” and not for “speculative” purposes."
Ironically, less than a year later, the Fed noticed that some loans were being diverted to "securities purchases". (Egad! Speculation.) So, in 1925, they began to tighten. The economy slowed a bit but nothing painful. So far, so good. By 1927, the aptly named Benjamin Strong (New York Fed President) successfully pressed for a policy of ease. It was widely assumed that Strong had hoped to create a climate to assist Britain and its struggles with the gold standard. The regional presidents rebelled, sensing some of the new money was moving into the stock market and other speculations. Strong then strong-armed them, however, and thus the New York Fed became the key voice in the system.
In response to the easing, gold began to move overseas and the Fed began to tighten in 1928. Gold began to return but, Strong died in October 1928 and the regionals saw a chance to regain influence. They kept rates up, citing the speculation going on in the stock market. There was some concern that this might hurt business but the Fed stayed tight. Somewhat ironically, the tight money hit both business and the stock market at about the same time. In August of 1929, Industrial Production began to fall just as the market rally topped out.
Despite efforts, the market withered in 1932 as did the economy. Under great pressure from Congress, the Fed embarked on a massive open market operation (a huge QE of its time). The program started in April of 1932 and was quickly ended in August of 1932. The reason it ended quickly was that the primary result of the program had been a huge jump in excess free reserves. The Fed assumed that policy was easy as could be since money was just laying around in banks vaults (sound familiar?).
The excess reserves would lay fallow in the vaults through much of the 1930's. The Fed feared that the reserves might be suddenly mobilized (lent out). That could spark wild inflation so they sopped up a chunk by increasing reserve requirements by 50%. A new recession followed.
Trial and error and error.