FEDERAL RESERVE POLICY AND BRETTON WOODS Michael D. Bordo Owen F. Humpage Federal Reserve Bank of Dallas 18 September 214
Introduction The Bretton Woods system was designed to correct the perceived problems of the interwar Competitive devaluations, free falling exchange rates, protectionism, unemployment and deflation It established an adjustable peg system with capital controls This allowed members to pursue domestic stabilization goals It was a compromise between the gold standard and floating and between the US and the UK
Introduction The system which emerged in the late 195s began to confront persistent problems with macroeconomic adjustment, exchange rate credibility and adequate liquidity The US dollar became the key international reserve and vehicle currency. This required a credible commitment by the U.S. to price stability a necessary condition to sustain the system
Introduction In the early years persistent U.S balance of payments deficits supplied the world with the dollar and gold reserves needed to maintain their parities in a growing economy. But by 196, just as Bretton Woods was becoming fully functional concerns over whether the U.S. had sufficient gold reserves to back the ever expanding dollar liabilities held by the rest of the world began to surface There was now concern over the dollar s convertibility and some European countries resented the dollar s exorbitant privilege This put great pressure on U. S. monetary authorities to attach high importance on external objectives This conflicted with the prevailing Keynesian paradigm to maintain full employment
Introduction In this global environment we ask how international considerations may have affected U.S. monetary policy. Between 196 and 1973 Federal Reserve policy makers often mentioned balance of payments concerns in their deliberations and policy statements On a few occasions, especially during crises they adjusted policy slightly and temporarily because of international considerations
Introduction But overall U.S. monetary policy focused primarily on the state of the real economy and unemployment Fed policy makers typically treated balance of payments objectives as superfluous. This attitude was possible because the Fed viewed expanding capital constraints, efforts at international cooperation and sterilized foreign exchange operations as relieving monetary policy of responsibility for international events
Introduction Also accountability for international events in the 196s was shifted to the Treasury These non monetary policies were often successful in the short-term. But ironically by eliminating the balance of payments as a constraint on U.S. monetary policy they allowed the Fed to create the accelerating and entrenched inflation that doomed Bretton Woods This ultimately made the outcome worse These themes we develop in the paper.
Figure 1: Gold and External Dollar Liabilities 14 Gold Stock External Dollar Liabilities Official Dollar Liabilities 12 Billions of Dollars 1 8 6 4 2 1951 1953 1956 1959 1962 1965 1968 197 1973
Figure 1: Gold and External Dollar Liabilities 14 12 Gold Stock External Dollar Liabilities Official Dollar Liabilities Gold market turmoil Billions of Dollars 1 8 6 4 2 1951 1953 1956 1959 1962 1965 1968 197 1973
Figure 1: Gold and External Dollar Liabilities Billions of Dollars 14 12 1 8 6 4 2 Gold Stock External Dollar Liabilities Official Dollar Liabilities Gold market turmoil NOT A FUNDAMENTAL PROBLEM 1951 1953 1956 1959 1962 1965 1968 197 1973
Stopgap Measures: TO IMPROVE BRETTON WOODS: - Gold Pool - General Agreement to Borrow TO IMPROVE THE US BALANCE OF PAYMENTS - Capital Restraints - Foreign-Exchange Operations
Operation Twist: 196-1964 Simultaneously achieve internal and external policy objectives by twisting yield curve: - increase short-term rates & keep long-term rates from rising - FOMC dissents Augmented with: discount-rate hikes, regulation Q easing, reserve-requirement cuts
Figure 6: Treasury Yields 6 1 Year Bond 1 Year Bond 3 Month Treasury Bill 5 Operation Twist 4 3 2 1 YIELD CURVE TWISTS 1959 196 1961 1962 1963 1964 1965
Figure 4: Net Free Reserves 16 14 12 1 8 6 4 2 Excess Reserves Operation Twist POLICY EASE Borrowed Reserves 1959 196 1961 1962 1963 1964 1965 1966 1967 1968 1969
Figure 5: Real Time Taylor Rules 12 1 Rule 1 Rule 2 Fed Funds Rate Operation Twist 8 6 SOMEWHAT STRINGENT 4 2 1958 1959 1961 1962 1964 1966 1967 1969 197 1972
Compatible Objectives: 1965-69 Policy problem: inflation & external imbalance lead to monetary tightening - administration & congress object - policy fails to be tight enough Capital controls ramped up Stop-go policy response Fed responds to international crises
Figure 2: Inflation Rates 16 14 12 United States Other G1 Compatible Objectives 1 8 6 INFLATION ACCELERATES 4 2-2 -4 1948 1951 1954 1957 196 1963 1966 1969 1972 1975 1978
Figure 4: Net Free Reserves 16 14 12 1 8 6 4 2 Excess Reserves Borrowed Reserves Compatible Objectives POLICY TIGHTENS 1959 196 1961 1962 1963 1964 1965 1966 1967 1968 1969
Figure 3: Federal Reserve Policy Rates 12 Effective Federal Funds Rate Discount Rate 1 Compatible Objectives 8 6 DISCOUNT RATE HIKE 4 2 1959 1961 1963 1965 1967 1969 1971 1973
Figure 3: Federal Reserve Policy Rates 12 1 8 Effective Federal Funds Rate Compatible Objectives STOP GO POLICY Discount Rate 6 4 2 1959 1961 1963 1965 1967 1969 1971 1973
Figure 3: Federal Reserve Policy Rates 12 Effective Federal Funds Rate Discount Rate 1 8 Compatible Objectives BRITISH POUND DEVALUED 6 4 2 GOLD POOL COLLAPSES 1959 1961 1963 1965 1967 1969 1971 1973
Figure 5: Real Time Taylor Rules 12 1 Rule 1 Rule 2 Fed Funds Rate Compatible Objectives 8 6 4 2 Not tight enough 1958 1959 1961 1962 1964 1966 1967 1969 197 1972
Benign Neglect: 197-1973 Policy dilemma: Internal & external objectives conflict Cost-push inflation - monetary policy promotes growth at potential - capital controls for balance of payment Stop go policy
Figure 2: Inflation Rates United States Other G1 16 Benign Neglect 14 12 1 8 6 4 2-2 -4 1948 1951 1954 1957 196 1963 1966 1969 1972 1975 1978
Figure 1: Gold and External Dollar Liabilities 14 12 Gold Stock External Dollar Liabilities Official Dollar Liabilities Benign Neglect Billions of Dollars 1 8 6 4 2 1951 1953 1956 1959 1962 1965 1968 197 1973
Figure 1: Gold and External Dollar Liabilities Billions of Dollars 14 12 1 8 6 4 2 Gold Stock External Dollar Liabilities Official Dollar Liabilities Developments over [1971] brought increasingly into question whether conventional monetary and fiscal policies alone were adequate to combat cost-push inflation and deterioration in the U.S. balance of payments while continuing to promote vigorous recovery Benign Neglect 1951 1953 1956 1959 1962 1965 1968 197 1973
Figure 3: Federal Reserve Policy Rates 12 1 8 Effective Federal Funds Rate Discount Rate Benign Neglect Policy eases 6 4 2 1959 1961 1963 1965 1967 1969 1971 1973
Figure 3: Federal Reserve Policy Rates 12 1 8 Effective Federal Funds Rate Discount Rate Benign Neglect Gold Window to Smithsonian 6 4 2 1959 1961 1963 1965 1967 1969 1971 1973
Figure 5: Real Time Taylor Rules 12 1 Rule 1 Rule 2 Fed Funds Rate Benign Neglect 8 6 4 2 Too easy 1958 1959 1961 1962 1964 1966 1967 1969 197 1972
Conclusion International considerations carried little weight in FOMC decisions. - shaped broad contours of policy (Operation Twist) - responded to crises (pound devaluation) Stopgap policy removed the external constraint on monetary policy Great Inflation ended Bretton Woods The stopgap measures ultimately contributed to Bretton Woods demise
FEDERAL RESERVE POLICY AND BRETTON WOODS Michael D. Bordo Owen F. Humpage Federal Reserve Bank of Dallas 18 September 214