The Federal Reserve has always been a curious institution. Its board of governors, located in Washington, DC, oversees a system that includes 12 regional banks, mixing centralization with federalism. Created by legislative fiat in 1913, the regional banks are private corporations meant to advance the public interest. Neither the White House nor Congress determines the Fed’s budget, though each year the bank returns a surplus to the government—almost $100 billion in 2014 alone. Members of the Board of Governors, including the Fed chair, are appointed by the president and confirmed by the Senate; heads of the regional banks are chosen by local boards of directors meant to represent their communities, a vague ideal that in practice usually means white men with backgrounds in finance. The arrangement is undemocratic, and it might be unconstitutional. As one official summarized matters: “To some extent, the Federal Reserve considers itself government. Other times, when it serves, it considers itself not government.”
Today one of the most powerful agencies in the world, the Fed was regarded at its founding as one of Progressivism’s representative achievements—a Food and Drug Administration for the money supply. It was a bipartisan project whose supporters, ranging from The Wall Street Journal to William Jennings Bryan, hoped to sterilize political conflicts by conferring authority on experts. This authority had stark limits. “We have other agencies in the United States,” Woodrow Wilson asserted in 1912, “that are much more powerful than a central bank.” Designed to facilitate the workings of the gold standard, provide credit during financial panics, and smooth interest-rate fluctuations brought about by the rhythms of the agricultural cycle, the Fed was meant to have a passive role. “After the institution has been going ten or fifteen years,” said one monetary specialist, “it will almost run itself.”
World War I extinguished that hope. It also initiated a period of frenetic innovation among Fed officials scrambling to comprehend a changed order. “I am frank to say that we knew mighty little about it,” recalled the first head of the Federal Reserve Bank of New York. Even so, ignorance didn’t prevent the Fed’s directors from wielding influence. After the war, as Wilson’s cherished League of Nations languished in the Senate, monetary tightening induced by the Fed caused a wave of deflation that spread across the globe and curtailed radical movements on both the left and right—a transformation of geopolitics as significant as anything Wilson had envisioned for his parliament of man.
A decade later, misguided policy-making at the Fed pushed the United States further into the Great Depression. During Franklin Roosevelt’s presidency, the bank retreated. Fearful of losing what authority they still possessed to the Treasury, Fed staffers had little firepower in departmental turf wars. Their position eroded further when real conflict broke out with World War II, and monetary policy was subordinated to the effort to prop up government finances. By 1945, the Federal Reserve was weaker than at any time in its history.
Inflation supplied central bankers with a rationale for reclaiming their lost clout. Though persistent inflation is an accepted fact of life today, in the middle of the 20th century it was still a novel phenomenon to Americans. Prices had risen and fallen across the 19th century, but they had demonstrated more stability over longer horizons: In the United States, the price level in 1910 was about the same as it had been 40 years earlier. Inflation hadn’t figured into the debates over the Federal Reserve’s creation, because legislators assumed the gold standard would determine the price level over the long run. But decades of change—the breakdown of the gold standard, the ascent of robust welfare states, and the growing conviction that small increases in inflation could boost employment—had created an environment more vulnerable to climbing prices. With the shadow of the Great Depression still hanging over economic debates, inflation appeared a small price to pay for steady employment.