the origins of federal reserve bank power over the economy

A fascinating historical oddity gleaned on the train this morning
while reading Lords
of Finance: much of the extensive power wielded by the Fed
(including open market operations) developed in the 1920s as part of
an attempt to prevent runaway inflation.
The problem was that (during the Great War) a combination of borrowing
by European governments, capital flight, and the need to buy more
goods than the English and French economies could produce, a
significant percentage of the world’s gold moved from Europe to the
US. For reasons having to do with repayment of the war debt and the
collapse of the major European economies during the war, this trend
continued during the early 1920s.
Since the US was officially on a gold standard, this meant inflation -
the money supply was theoretically dependant on the country’s gold
reserve. The NY Fed’s estimate was that, even after the immediate
post-war period, the increase in the gold reserve would require a
*doubling* of prices in order for the economy to absorb the increase
in the money supply.
Since the Fed at the time viewed its goal as being maintaining a
*stable* currency and preventing inflation, this was a bad thing, even
though the orthodoxy of the time required a gold standard. So it
developed techniques, above and beyond raising interest rates, to
suppress money supply growth in order to prevent the inflation caused
by the influx of gold.
October 25, 2011 at 09:43AM