Well that went quickly! The first half of 2023 is officially over, and with it, certain concerns seem to have abated, while other topics seem to occupy a great deal of our mind-space. One governmental institution that constantly captures media attention due to its fascinating evolution and present-day significance, is the U.S. Federal Reserve Bank, commonly known as the Fed. In this piece, we aim to provide a concise overview of its evolution, significant milestones, and unwavering commitment to combating inflation. Established over a century ago in 1913, the Fed was created with the objective of establishing a stable monetary framework and safeguarding against financial crises. Throughout its history, the Fed has implemented diverse monetary policies to ensure price stability, eventually adopting a "dual mandate" of maintaining both price stability and full employment.
Creation and Early Years
The Fed was born out of the need for a more stable and flexible financial system following a series of severe financial panics in the late 19th and early 20th centuries. On December 23, 1913, the Federal Reserve Act was signed into law, creating the Federal Reserve System as the central banking authority of the United States. Its primary objectives were to maximize employment, stabilize prices, and moderate long-term interest rates.
The Great Depression and the New Deal
The Fed faced its most significant challenge during the Great Depression of the 1930s. The severity of the economic downturn exposed weaknesses in the central bank's policies. Critics argued that the Fed's restrictive monetary policies exacerbated the crisis, leading to a prolonged period of deflation and economic contraction. (As a side note, the Fed website defines “monetary policy” as actions undertaken to influence the availability and cost of money and credit to help promote national economic goals.) In response, the New Deal introduced reforms and regulatory measures that expanded the Fed's powers, providing it with greater tools to stabilize the economy.
The Post-War Era and the Bretton Woods System
Following World War II, the Fed played a crucial role in establishing the Bretton Woods system, a global monetary framework aimed at promoting stability and exchange rate management. Under this system, the U.S. dollar was pegged to gold, and other currencies were pegged to the dollar. The Fed's responsibility was to maintain the convertibility of the dollar to gold by adjusting interest rates and intervening in foreign exchange markets when necessary.
The Era of Inflation
In the 1970s and early 1980s, the United States faced a significant inflationary period, commonly thought to be the result of rising energy costs, increased government spending, and loose monetary policy. The Fed, under the leadership of Paul Volcker, implemented a series of aggressive measures to combat inflation. This included tightening monetary policy, raising interest rates to unprecedented levels, and adopting a more transparent and rules-based approach to monetary management. As anyone who remembers that period can attest, such high-interest rates were unheard of in the United States! Michael Hatch vividly recalls his parents' relief when they secured a 16.5% mortgage following an unexpected out-of-state relocation, only to refinance it promptly when interest rates eventually dropped. Interestingly, most Fed leaders before Paul Volker were oftentimes background policymakers, little known by the public.
The Greenspan Era and Forward Guidance
Alan Greenspan, who served as Chairman of the Federal Reserve from 1987 to 2006, oversaw a period of relative economic stability and low inflation. During his tenure, the Fed began utilizing "forward guidance," a communication strategy aimed at providing the public and financial markets with insight into future monetary policy decisions, aiming for “transparency” and taming expectations. However, neither Greenspan nor the Fed, with all their expertise, could anticipate the transformative developments witnessed in the past two decades (e.g. shale oil boom, the financial crisis of 2007/08, and the technology boom exemplified by the introduction of the iPhone / smartphone in 2007).
Recent Challenges and Innovations
In the wake of the 2008 global financial crisis, the Fed implemented extraordinary measures to stabilize the economy. These included cutting interest rates to near zero, implementing large-scale asset purchases (QE or “quantitative easing”), and providing liquidity support to financial institutions. Additionally, the Fed has adopted a 2% inflation target and has started focusing on a more comprehensive approach to assessing labor market conditions and economic indicators, but some critics argue the Fed should stay in its lane and avoid “mission creep” into every societal economic topic.
The Fight Against Inflation Today
Previously, the Fed focused on a limited data set, such as the M2 money supply, but it now employs a broader, data-dependent approach, closely monitoring indicators such as employment rates, inflation expectations, and economic output to guide its monetary policy decisions. While the Fed remains committed to addressing inflationary pressures, many commentators criticized the Fed for acting too late to start raising interest rates just 15-16 months ago, when consumers in the United States had been experiencing significant inflation for close to two years.
A summer intern once asked us: "How does the Fed measure inflation?" A simple question, yet devilishly complex to answer. The inflation labyrinth is influenced by numerous factors, and it attracts the attention of some of the brightest economists worldwide. At its core, inflation stems from the imbalance between the supply and demand for specific goods or services. However, as technology advances, comparing the prices of certain items becomes challenging. Some inflationary items, like the price of gasoline, raise concerns, whereas others may be more tolerable due to the preferable outcomes they offer, such as a wildly more successful surgical outcome, even if the cost has doubled. We all know medical inflation is high, but life is also precious, and in other areas, we can make alternative choices such as preparing meals at home more regularly, versus eating out.
We have a keen interest in monitoring how inflation affects your standard of living and financial security. With M2 supply of money heading down for the first time in modern history, (illustrated on the accompanying chart) we do feel like the near-term inflation outlook has improved. While the Federal Reserve has faced its share of challenges and criticisms, it has generally been a force for good, striving to maintain the stability and prosperity of the United States economy.
If you would like to update your financial projections or have any questions regarding the Federal Reserve, inflation, or other topics, please feel free to reach out to us.