When the Fed plays follow the leader, it steers us all toward inflation

The mid-1950s is a period of U.S. history that is famously known as “happy days.” Dwight Eisenhower was sworn in as the 34th president in 1953 and promptly negotiated a truce to end the Korean War. Under chairman William McChesney Martin, the Federal Reserve used its newly negotiated monetary policy independence from the U.S. Treasury to reduce inflation from almost 9.5 -percent in 1951 to virtual price stability. But price stability came at the cost of two recessions which raised the ire of many in Congress. 

In 1959, the Joint Economic Committee convened hearings on “Employment Growth and Price Levels.” The committee’s final staff report was critical of Fed’s policies arguing that they slowed economic growth without preventing inflation. According to Federal Reserve historian Alan Meltzer, the report “provided one of the earliest statements of the prevailing Keynesian policy position that rose to influence in the 1960s — that there is a permanent trade-off between inflation and unemployment or growth [the so-called Phillips curve], that the Federal Reserve’s concern about preventing inflation permanently lowered either the growth rate or the level of output…”

The Kennedy and Johnson administrations, aided by their policy advisors Paul Samuelson, Robert Solow and Walter Heller — virtual giants in the economics profession — used the Joint Economic Committee’s findings to push the narrative that full employment and acceptable growth could only be achieved through “policy coordination” among the Fed, Congress and the executive branch. Policy coordination undermined Federal Reserve independence. It required the Fed to pursue inflationary policies to facilitate successful Treasury debt financings as deficits grew to support the Phillips curve-driven policies of the Kennedy and Johnson administrations. 

Fed chairman Martin, while personally committed to price stability, believed in the Federal Reserve’s “independence within the government.” According to Meltzer, this meant that “if an elected administration proposed and Congress approved budget deficits, the Federal Reserve had to help finance part of them.” Policy coordination required the Fed to adopt the “same objectives and attach similar weights to employment, price stability and the [balance of] payments deficit” as the Congress and administration.

If chairman Martin was only a reluctant practitioner of policy coordination, rarely meeting with four of the five presidents he served excepting President Johnson, who famously pressured Martin for lower interest rates, his successor Arthur Burns was an all-in advocate. Burns not only advised President Nixon before becoming Federal Reserve chairman but actively consulted on the administration’s policies after he was appointed. Burns epitomized Richard Nixon’s view of an independent Federal Reserve chairman when Nixon reportedly said of him, “I respect his independence. However, I hope that independently he will conclude that my views are the ones he should follow.”    

The legacy of Federal Reserve policy coordination was “the Great Inflation,” a period of accelerating inflation and stagnating growth that began in 1965 and did not end until Paul Volcker became Federal Reserve chairman and abandoned the practice of policy coordination. During this regrettable historical episode, 12-month CPI inflation rates reached 13.5 percent in early 1980 before declining from the pressure of Fed-induced historically high interest rates and two recessions that saw unemployment rates reach 11 percent. 

Today we face a situation where three key Federal Reserve Board positions are open for nominations in the coming months, the chairman, the vice-chairman and the vice-chairman for bank supervision. By all actions and appointments, this administration is more focused on “policy coordination” than any in recent memory. For this administration, policy coordination revolves around party loyalty and a commitment to further a radical progressive agenda. Some examples include a head of the Department of Homeland Security who appears to favor open borders and the rights of illegal migrants over enforcing existing law and protecting the property rights and safety of U.S. citizens; an attorney general that commits Department of Justice resources on investigations of citizens who express views counter to those of the administration at school board meetings; and a nominee for comptroller of the currency who wants to replace our private banking system with a government-directed system for allocating credit.   

In 2016, Senate Banking Committee member, Sen. Sherrod Brown (D-Ohio), praised the defeat of the so-called “Audit the Fed” bill because it would “undermine the Federal Reserve’s independence and inject politics into monetary policy.” In 2020, Brown as the ranking member of the committee vehemently objected to the nomination of Judy Shelton to serve as a Federal Reserve Board governor. He argued, ”Fed independence matters. We know economies with independent central banks have less price volatility, fewer bank panics, and more stable economies. But one of the nominees before us today doesn’t believe in an independent Fed, and has spent her entire career advocating for policies that would make our economy more volatile, and give families and businesses even more to worry about in an uncertain world.”

In a world where progressives believe in “modern monetary theory,” a theory that argues monetizing massive government deficit spending is not only sound monetary policy for a country like the U.S., but the key for funding the social spending wish list of the far left, what kind of Federal Reserve candidates is the Biden administration likely to nominate? What will they have to promise in confidence? Will Senate Banking Committee Chairman Brown continue his long-standing crusade to protect Federal Reserve independence?

Or are we headed for the Great Inflation Redux? 

Paul H. Kupiec is a resident scholar at the American Enterprise Institute (AEI), where he studies systemic risk and the management and regulations of banks and financial markets.