The Fed’s Got Inflation Backwards

Central banks endlessly fascinate me. The more I research them the more contradictions I find, particularly since their missions and impacts changed over time. Take the Federal Reserve (Fed), for example. It was originally created to countercyclically balance volatile market forces in times of stress. However, the evolution of financial concepts—most notably money and inflation—have turned the Fed upside down. It no longer acts as a stabilizer. Rather, the Fed’s actions are now procyclical. Today, its monetary policy is fanning the flames of the shortage-induced inflation.

From cronies to currency to macro

Central banks are relatively new phenomena in the modern world. Like many things, they’ve evolved. The first ones were private organizations that were granted special, privileged status by governments in return for purchasing their debts. Specifically, these early central banks were granted monopolies over the issuance banknotes (which served as national currencies) in exchange for lending governments much needed funds. These include the Swedish Riksbank (1668), the Bank of England (1694) and the Banque de France (1800).

Central banks have long histories of banknote monopolies. Source: Gary Gorton, The Future of Money

Central banking evolved (in part) with the founding of the Fed. The Fed was specifically created to help stabilize the volatile commercial banking sectors after the Panic of 1907. It was supposed to provide an elastic currency at times when interbank lending left the private sector short on liquidity and susceptible to bank runs.