Monetary Policy & Central Banking

On the evening of October 6, 1979, eight weeks into his Fed chairmanship, Paul Volcker convened an emergency Saturday meeting of the Federal Open Market Committee. US inflation had reached 13%; the dollar was collapsing; previous tightening attempts had been timid. Volcker shifted operational targets from the federal funds rate to bank reserves, accepting whatever rate volatility resulted. Over the next three years the funds rate hit 20%, unemployment hit 10.8%, Volcker was burned in effigy on the steps of the Eccles Building, and inflation broke — 13.5% in 1980 to 3.2% by 1983. October 1979 is the conventional starting point of the modern central-banking era: independent technocratic authorities, inflation targeting as operational objective.

Four jobs sit under one roof, and it is worth seeing why they ended up together. A central bank sets the short-term interest rate, and through it the price of credit across the economy. It supervises the banks. It stands ready to lend when a solvent bank cannot borrow — Bagehot's rule, lend freely, at a penalty rate, against good collateral, designed to end a panic without rewarding the reckless. And it runs the plumbing through which payments finally settle. The four cohere because each demands the same thing: an institution able to create money at will and trusted not to. That trust is the mechanism, and it explains the era's central innovation. If the public expects prices to rise, it builds the expectation into wages and contracts, and the expectation delivers the inflation it predicted. Breaking that loop needs a bank whose promise is believed — which is why independence from the finance ministry, an explicit numerical target, and the habit of explaining decisions in public became standard equipment rather than ornament. The point of announcing a target is not the number; it is to hand the public something to hold the bank to. Since 2008 the toolkit has grown because the original tool ran out. Once the policy rate reaches roughly zero it cannot be cut further, so central banks turned to the levers left: paying interest on reserves, promising in advance how long rates would stay low, and buying long-dated assets outright to press down the yields a short rate could no longer reach. Balance sheets grew by an order of magnitude in consequence. The inflation of 2021–23 was the first real test of the arrangement. Rates rose faster than at any time since Volcker, and the result that mattered was not the pace but that expectations of future inflation barely moved — the public went on believing the target would be met, which is precisely the credibility the whole design exists to buy.