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The Monetary Theory and Practice of the Federal Reserve, 1914–35 https://doi.org/10.17863/CAM.123976 Brown, Edward Needham, Duncan Since its inception in 1913, the US Federal Reserve System (Fed; System) has been home to some of the world’s best minds in law, statistics, economics, and public policy. The collective impact of these individuals has not only influenced the lives of millions in the US, but of billions around the world. There are few institutions that rival the Fed’s influence, and even fewer where decision-making holds greater weight. Those at the Fed not only need to make the right decisions at the right time, but because so many people base their choices on the decisions made in that stone building on Constitution Avenue, the Fed’s leadership needs to maintain an unparalleled level of consistency in the monetary theories and practices they employ. For many years, the history of the Federal Reserve has captivated my attention. Five years ago, I became particularly intrigued by the Fed’s formative period. At that time, I found myself baffled not only by how poorly the System had navigated its most significant challenge—the Great Depression—but also by the inconsistency the institution exhibited in its early decision-making. I had numerous questions that lacked any definitive answers. What would cause the System to abandon its earliest monetary theory, the ‘Real Bills Doctrine’, almost immediately after it had opened its doors? What rationale existed for monetary officials keeping interest rates low in the months following WWI when inflation was high, but elevating them to unprecedented levels during the recession of 1920-21 when deflation had clearly gripped the US economy? What prompted the Fed to adopt an international approach to monetary policy in 1927, only to shift to an insular, autarkic approach in the following year? What factors influenced officials’ decision to build the foundations for an interventionalist, countercyclical policy in the early 1920s, only to ignore those principles during the Great Depression and sit ‘idly by as the banking system crumbled’?1 Scholars have found it quite difficult to answer these questions. I myself believed it was nearly impossible to reconcile such inconsistent behaviour. I first looked for analogues of capricious decision-making in nascent central banks, particularly the eighteenth-century Bank of England and the nineteenth-century Banque de France; however, I observed no justifiable parallels that would suggest that this was how fledgling central banks operated. I then 1 B. Eichengreen, Golden Fetters: The Gold Standard and the Great Depression, 1919-1939, NBER Series on Long-Term Factors in Economic Development (New York ; Oxford: Oxford University Press, 1992), p. 18. iv considered whether large external shocks, such as severe recessions and international conflicts, drove inconsistent behaviour, but I was confronted with a number of periods in which monetary decision-making remained fairly anchored alongside tumultuous circumstances. I even traced the history of economic thought backward—through the works of Walter Bagehot, Henry Thornton, Adam Smith, and David Hume—to find some justification for the variability in the Fed’s institutional thinking. All to no avail. Desperate for clarity, I turned to the modern era for answers. Reflecting on this period through the prism of contemporary economic thought, I wondered whether twenty-first- century central banking could provide insights that could help researchers better understand why the Fed behaved in the way it did. Could our present understanding of monetary policy (and the forces that we presume influence central bank decision-making) offer some explanation as to why the Fed behaved so mercurially during its first twenty-one years? Working from home in 2020 during the COVID-19 pandemic, a notification flashed across my computer screen that captured my attention. It read that, after a year-long public review, the Fed’s Board of Governors had decided to amend the System’s ‘monetary policy framework’ (MPF; policy framework)—or, in the words of Fed Chairman Jerome Powell, its ‘strategy for achieving its goals’.2 I immediately considered the specifics of the Fed’s earliest MPF. What were the System’s initial objectives? What strategies did it use to meet those objectives? Were these matters explicit in the Federal Reserve Act (FRA), or did early officials define them for the System? Perhaps most critically, did the Fed retain its founding principles as it matured—that is, did the Fed of the 1930s operate with the same strategies and goals as the Fed of the 1920s or even the Fed of the late 1910s? Feeling I needed to take a step back and examine the more granular components of a MPF, I put these questions aside. If this modern exposition of central bank ‘strategy’ were to add any value to my investigation of the early Fed, I first needed to flesh out the MPF’s inner workings and determine whether the System in fact retained these characteristics during its formative years. What I discovered in my deconstructive dive was rather unexpected. With respect to the concept’s structural foundations, I ascertained that beyond mere ‘strategy’, MPFs represent the systemisation of the theories and practices that underpin all monetary decision- making. Beyond being a mere playbook for monetary policy operations, as Powell suggests, 2 J. H. Powell, ‘Opening Remarks: New Economic Challenges and the Fed’s Monetary Policy Review’ (Speech, Challenges for Monetary Policy: A Symposium Sponsored by the Federal Reserve Bank of Kansas City, Jackson Hole, WY, 22-24 August). v MPFs constitute the accepted conventions upon which a central bank’s monetary policy is constructed. They delineate not just what central bankers should do in particular circumstances (practice), but also why they should do it (theory). In the course of investigating whether the Fed employed a specific MPF during its early years, I discovered that this was, in fact, the primary source of the variability in the Fed’s institutional behaviour. The Fed did indeed possess a formal blueprint for guiding its decision-making during its first two decades; however, rather than operating within a uniform policy framework—that is, one which maintained invariant theoretical and practical arrangements—the Fed employed numerous, distinct policy approaches. Officials routinely modified their objectives, alternated among a handful of strategies, and utilised various quantitative metrics to guide the System’s operations. Never were officials wedded to a set of established rules or obligated to adhere to a fixed set of theoretical and practical conventions. They entrusted the System’s administration to a myriad of interchanging standards, and then shifted among those standards given the state of the domestic and international economies. The question I then asked—which became this dissertation’s primary focus—was why did those at the Fed feel the need to adjust the System’s theories and practices so frequently? The argument presented in this thesis posits that two material constraints prevented the Fed from operating within a uniform policy paradigm during the 1914-35 period. The first was the ambiguity inherent in the FRA itself. Rather than explicitly delineating how the Fed should operate, the System’s founders deferred to the Fed’s early officials on a number of administrative issues—most notably, the selection of the institution’s goals, strategies, and policy tools. Such latitude has been championed by numerous scholars, since it afforded officials considerable autonomy to construct the most dynamic policymaking apparatus. However, by allowing the System’s early operators to specify these matters, it also granted them, by default, the prerogative to amend those directives on an ad hoc basis, which is precisely what they did. Instead of operationalising monetary theory and practice within a well-defined scope, one with coherent goals and an express strategy for meeting those goals, officials commissioned unique policy schemes that were contingent upon the most immediate economic headwind. Theory and practice thus evolved unpredictably, and were governed largely by the vicissitudes of the domestic and international economies rather than by policy standards set by Congress. The second contributing factor to the inconsistency seen in the early Fed’s theories and practices was a set of deterministic conditions that directly influenced the System’s vi policy orientation. In this thesis, it will be demonstrated that specific agents induce adjustments in the theories and practices that central banks employ, and each of these agents contributed to the evolution of the Fed’s own understanding of monetary theory and practice during the period. This is explained in further detail in Chapter One; the salient point here is that these conditions, when coupled with limited circumscription in how those leading the Fed specified institutional objectives, pressured the Fed’s MPF to mutate in response to a variety of conjunctural economic settings rather than to navigate those settings within an established policy remit. Ultimately, the interaction of these two forces resulted in an era of administrative uncertainty and poor monetary performance. After two decades of operations, the Fed found itself in the midst of the Great Depression without a clear strategy for correcting the deteriorating economy. The institution was not only uncertain of its precise role within the US political system, but also sceptical of its influence on the American economy and perplexed by how it should navigate future crises. As a result, in 1935, President Franklin Roosevelt assumed control of the nation’s monetary policy through dollar devaluation and expansive gold policy, while simultaneously enacting legislation that would centralise—and strengthen—the Fed’s monetary authority. Such contradictory action may appear illogical to the casual observer; however, given the System’s record of inconsistent decision-making and its abysmal performance in providing remedial action to the Depression, usurping the Fed’s immediate duties while affording officials time to formulate a more robust operating framework was perhaps the most prudent course of action for the president. The Fed thus concluded its first twenty-one years much in the manner it had begun. In 1935, just as in 1914, officials had to determine what place the Fed would occupy in the domestic economy, as well as consider the role the institution would play on the international stage—neither of which was clear to those leading the System. The following pages are my attempt to tell this story. It is a story which endeavours to provide some sense of clarity to an era of seemingly inscrutable institutional behaviour. It is an account that explores, through the lens of the System’s MPF, the rapid transformations in the monetary theories and practices that underpinned the Fed’s decision-making, and the rationale behind those transformations. The text begins by detailing the specifics of the Fed’s initial MPF (broadly outlined in the FRA, but more precisely defined in the months after its enactment) and then follows the System as it encountered a series of conditions that forced adjustments to that framework over time. vii A handful of conclusions are presented in this research. Some may be considered controversial among my monetary history colleagues. However, the research’s principal contribution should be largely indisputable. This dissertation’s central hypothesis is that one cannot fully understand the behaviour of the early Fed—or, for that matter, any central bank in any period—without an appropriate appreciation of the ways in which MPFs influence central bank behaviour, and of how certain conditions influence the evolution of MPFs. Viewed in this light, it is not at all surprising that the Fed seemed fickle in its early years. What is surprising is that there was not greater variability in the theories and practices that the System employed during this time. E.C.B Cambridge July 2025 University of Cambridge 2025-07-25 Thesis Doctoral Doctor of Philosophy (PhD) eng https://www.repository.cam.ac.uk/handle/1810/393797 embargo 2026-12-15 https://www.repository.cam.ac.uk/bitstreams/23abf0e0-0519-4861-8f31-e049a5b53843/download c58dc505d67c05bc745fe0509167283a https://www.repository.cam.ac.uk/bitstreams/30216ba0-b10f-4f00-b516-adc40d9413fb/download 87eda9de84448d1f82354d60eee3eb5f http://purl.org/NET/rdflicense/allrightsreserved Federal Reserve Monetary Policy Frameworks Monetary Theory