ABSTRACT
Formulating and conducting an appropriate US monetary policy over most of the twentieth century was fraught with great difficulty for many reasons. There was a sea of change in terms of the institutional environment, structural changes within, and deregulation of the financial sector and a rapid technological revolution in the latter part of century. Given that the major priority of the Fed is to control inflation, and given the rise of monetarism in economic policy circles in the 1960s and 1970s, monetary targeting was employed. Keeping the lid on inflation implied an adherence to a Constant Money Supply Growth Rule (CGR) in some form. However, the strict relationship between money and output went awry in the 1980s and so prompted a revision of monetary targeting as a monetary policy strategy. The Federal Reserve’s fight against inflation was thwarted by the deterioration of old empirical relationships caused by a rapidly changing economic environment in which it operated. Rampant inflation in the 1970s, partly a result of the oil crisis, tested the skill and nerve of the Fed. Executing an appropriate monetary policy was not only complicated by inflation and moving intermediate targets but also by financial innovation and a more open credit market. Thus, deregulation and greater competition had its costs. A less regulated financial sector brought with it greater credit risk, greater leverage and more volatility in prices. It is here that a serious conflict arises between the Fed and stock traders-as they are diametrically opposed. Stock traders want increased volatility in financial markets (in order to create profits) whereas the Fed wants to preserve economic and financial stability. There is a case for arguing that the abandonment of monetary targeting laid the foundation for the escalation of asset prices-as excess liquidity searched for a home. It will also be noted that although stocks were very interest rate sensitive for many yearsthey were less so in the 1990s. It was rapid money supply growth that fuelled the asset price bubble in these years. This chapter examines some of the challenges faced by the Fed in the recent era.
