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People-Side Economics: Who’s Afraid of the Federal Reserve?

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A black and white image of Paul Volcker edited over an orange and yellow swiftly increasing line graph.

“One of the greatest tricks central bankers–and the ruling-class interests that they serve–ever pulled was creating the impression that monetary policy is just a technical thing.” – Samir Sonti on the Federal Reserve.

Gloom shrouds the news on the economy. Workers get blamed for inflation and the common solutions on offer bring more pain. But when we center the interests of workers and communities, we get a different picture of the causes and cures for our economic woes. While wage increases can contribute to inflation, they don’t have to. Corporations can absorb higher wages by cutting profits or CEO salaries, for example. In fact, the increases in workers’ wages have barely brought them up to pre-COVID levels, while CEO pay and profits have increased exponentially. And there are other key sources of inflation such as energy prices and supply chain issues, that are more significant than wage increases.  

The Federal Reserve, usually presented as a gray eminence above the fray, actually plays out a distinct neoliberal agenda—one that sees higher unemployment as an aid in disciplining the workforce. In this fifth installment of our “People-Side Economics” series, CUNY’s Samir Sonti tells Convergence editorial board member Stephanie Luce how politics shaped the Fed – and  politics and organized power can change it.

Stephanie Luce: Let’s start off with some basics. Can you explain to our readers what the Federal Reserve (The Fed) is?

Samir Sonti: The Fed is basically the central bank of the United States. What that means is that it is the bank for all the banks. It’s sort of the apex of the financial system. Because all banks rely on it, it’s able to set conditions across the entire financial system—most importantly, interest rates. That means it can regulate the general level of interest rates across the entire economy.

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When you go to your bank to get a mortgage, for example, the interest rate you’re getting is in some way influenced by the Federal Reserve, because it’s at the top of the pyramid.

SL: What is the purpose of the Fed? What is the Fed trying to do? 

SS: The initial campaign to establish the Federal Reserve System was actually driven in large part by farmers who were affected by deflation, which is when regular prices decline. Deflation was a problem for them because farmers had to borrow to buy land, equipment, seeds, and so on—and they made those purchases based on expectations about the prices their crops would go for on the market. So, when prices dropped, there would be a lot of defaults on loans, bankruptcies, and so on. In the decades after the Civil War, this was a huge problem for farmers.

There were various causes of this deflation, but one factor was a chronically inadequate supply of money, especially in the countryside. If the total quantity of money doesn’t grow at the same rate as the volume of goods, prices are going to drop. And, in the view of populist farmers in the late nineteenth century, the reason there was a shortage of money was because Wall Street controlled the financial system and benefited from this scarcity. They wanted a democratic, public authority that would manage the supply of money and credit not in the interests of productive farmers and not financial investors.

Bankers, for their part, wanted what they called “sound money”—and sound money was money backed by gold at a fixed ratio. All lending and investment, from their perspective, depended on the value of money remaining sound over time—and that meant that the supply of money couldn’t grow. At the same time, though, they were worried about the social instability that deflation caused—especially because deflationary episodes were often triggered by financial panics which were pretty bad for bankers too.

The establishment of the Federal Reserve was basically a compromise between these two groups—farmers got a somewhat public authority that would manage the supply of money and credit around the country. And bankers got an institution that could stabilize the financial system and prevent panics. 

The point of all of this is simply to say that the Federal Reserve was established to deal with a very different set of problems from what it is now known for addressing: it was originally imagined as an institution that would combat deflation not inflation. And it emerged out of social struggle in which popular forces demanded greater public intervention into the functioning of the economy. 

Today, the Fed does the opposite. It uses interest rates to police inflation, even if this has disastrous consequences for workers by creating unemployment. It presents these actions as simply necessary and outside the scope of reasonable debate—but the idea that monetary policy is not political is, in fact, very new.

SL: Some people talk about the Fed and interest rates as if it’s all just a technical matter, but in fact, it’s very much a political institution. How should we make sense of the politics of the Fed today?

SS: One of the greatest tricks central bankers—and the ruling-class interests that they serve––ever pulled was creating the impression that monetary policy, and central banking, is just a technical thing.

Maybe it’s most useful to illustrate it through the actual history. I mentioned how the Fed was established out of conflict between farmers and bankers over control of the financial system, so in the first place, it was born through political struggle. But the creation of the institution didn’t resolve the fundamental tensions between these competing constituencies over how the system should be managed. Through World War I, which began just as the Fed was opening its doors, and its aftermath, this conflict over how the Fed should function continued to rage. 

Then in 1929 the market crashed, and the Great Depression began. This marks a new era in the Fed’s history. One of the first things the Roosevelt Administration did was banking reform. There are a few different pieces to this, like the Federal Deposit Insurance (FDIC). But these banking reforms also had an effect on the Federal Reserve. They tried to ensure that the Fed would cooperate with the larger economic programs of the New Deal. And this meant focusing on facilitating longer term investment and ensuring that the government could borrow and spend on New Deal programs.

This arrangement lasted through the 1930s, and then deepened during WWII, when the Fed played a central role in helping the government finance its massive war effort.

During WWII, the government maintained price controls on everything and successfully kept inflation at bay. I should say that there were also wage controls during the war. But business campaigned hard against price controls and after the war, the government removed them and inflation shot up. And this is where the politics start to really sharpen.

SL: How did the Fed evolve after WWII?

SS: Even after the war, business and the government needed access to credit for long-term investment. Major infrastructural programs require financing over long horizons, which means that you need credit and you need credit at rates that are manageable to service over time. A central bank can help to provide that.

But this kind of program runs the risk of inflation and so a burning political question in the post-war era became: what kind of economy are we going to have? Is it possible to have a full employment economy with a strong safety net and avoid inflation? 

Accomplishing that would have required that the government continue to play a major role in managing prices and the economy more generally through wage and price controls, limits on certain kinds of consumption (aka rationing), steep progressive taxation, and substantial public investment to make up for the decline in private investment that would result from lower profit rates. Progressive unionists understood that this was necessary and mounted a real fight for it after WWII. But, as you’d expect, the corporate class fought back—and no such regulatory regime was erected.

In the absence of a more comprehensive—and equitable—inflation control system, the Fed stepped in and began policing inflation. In what’s been called the Fed-Treasury Accord of 1951, the central bank effectively told the Truman administration that it would no longer support the government’s attempts to undertake public investments and would instead focus principally on using interest rates to combat inflation – whatever the cost.

SL: By the early 1950s, it’s clear the Fed has its goal, and its political purpose is controlling inflation. But we don’t see the major impact of that really until the late 1970s and early 1980s, right?

SS: The new view about the role of the Fed gets sort of formalized in 1951. But there still wasn’t a universal consensus outside the Federal Reserve that this is the appropriate direction to go. There was still opposition within the labor wing of the Democratic Party.

Central bankers are very much aware of the political dynamics that surround them. And so while they had moved away from a sort of cooperative position with the federal government, they knew they were constrained on how far they could move. But generally, the approach that they started to take was to police inflation with higher interest rates.

It is important here to emphasize the degree to which they grew to see inflation as resulting from  working class power. This was a relatively new dynamic because, prior to the New Deal, the labor movement hadn’t ever had this kind of structural macro-economic power. This idea of union power as a serious macroeconomic threat loomed large in the minds of central bankers through the postwar period. It can’t be overstated how much this shaped their thinking in the decades between the 1950s and 1970s. 

The turning point came in the 1970s for a particular reason. In the 1950s and 1960s, central bankers and the mainstream economics profession more broadly came to believe that there was a tradeoff between inflation and unemployment. During periods of strong economic growth, unemployment should fall and inflation would pick up; during downturns, the opposite would occur, with unemployment rising and inflation slowing down. Fed officials saw their role as helping to moderate this business cycle—raising interest rates when the economy was hot, to prevent inflation from getting out of hand; lowering interest rates when the economy slowed, to prevent a recession from getting too bad.

In the 1970s, this all broke down. For a variety of reasons (including an oil crisis), during that decade the economy slowed but inflation soared. This collision of a stagnating economy and inflation came to be called stagflation. The question then became what to do: the old approach could only address one of the factors by making the other worse.

The mainstream story is that in the late 1960s, as the domestic economy boomed due to military spending on the Vietnam War, the Fed failed to sufficiently raise interest rates and therefore let inflation get out of control. In fact, the trajectory of interest rates over the whole postwar period was only upward—and they were pretty darn high in the late 1960s and early 1970s. In fact, they were so high that labor liberals in Congress were pushing and successfully passing legislation to try to rein in some of the Fed’s authority to raise interest rates and to refocus the Fed back to its original commitments to longer term, productive investment.

SL: Tell us more about this turning point because the outcome has had a major impact on the role of the Fed for the last 40 to 50 years.

SS: By the late 1970s, inflation had been rising for over a decade. And it was quite clear to everyone, by this point, that there were really two paths that we could take. This was a “fork in the road” moment.

One path would involve robust controls of some kind: price controls, maybe some wage controls. With those, you would need more state planning. Because if you’re going to control prices, you will, by extension, limit profits. And that will likely lead to shortfalls of business investment, which can have adverse effects on employment. So, if our leaders had chosen this path, the government would need to step in and compensate for profit losses and public investment. So this path would involve a real state intervention into the economy. More government planning. 

In the 1970s, this is the direction many people thought things would go. We have to remember how contingent this all was. The balance of political power, the balance of class forces, whatever we want to call it, was relatively evenly matched compared to what we’re more familiar with now. So that was one possible direction that things could have gone.

The other path is to attack inflation through brute force: through monetary policy of raising interest rates through the roof, and through fiscal policy—cutting budgets and reducing federal spending. The costs of this path would include high unemployment alongside reduced social services. And it seemed to most reasonable, decent people through the 1970s that these costs were unacceptable. That is why the first option seemed possible.

But by 1979, with the appointment of Paul Volcker as the Chair of the Federal Reserve Board, the second path prevailed. Volcker was appointed by a Democratic President, Jimmy Carter. Whatever we want to say about him, Volcker was very clear about what he intended to do. It was clear that by picking Volker, this was the path that the Carter Administration was going to pursue. In the context of panic, there was a sense of a complete inability to really take steps to address the situation with better tools.  

The Volcker Shock. So Paul Volcker comes in and proceeds to raise interest rates to nearly 20%, provoking the deepest recession since the Great Depression. It was particularly hard for industrial areas, where many plants shuttered and never reopened. The labor movement has never really recovered from this. 

But in a few years, inflation came down. The Fed’s action certainly played a role, but there are a variety of factors that likely played a role, such as declining oil prices. But this certainly played a role. And so going forward, Volcker’s bold action was seen as a success. 

SL: This brings us to today. The Fed does what it does and I think most feel powerless in relation to it. Do we just accept the Fed as it is today? How do we think about challenging it?

SS: It’s a great question. The Fed is often described as the most anti-democratic institution in the federal government. I would argue that the judiciary is more anti-democratic than the Federal Reserve. Fed Board members are not lifetime appointees. They are all presidential appointees who are appointed every few years. They’re quite insulated but not totally insulated. 

We can’t predict what’s going to happen but, given that there are no alternatives currently on offer, the Fed seems likely to continue to raise interest rates. 

I think this sense of despair can maybe be overcome by two things. 

One: If we had other means of responding to inflation, and preventing it from getting to the level that it has gotten over the past year, the Fed wouldn’t be compelled to act with such blunt force in the first place. Getting to a place where we have other ways to address inflation calls for a general struggle to democratize the economy and for the federal government to play a role in managing prices. Especially the kind of specific prices that affect the inflation rate. Housing costs account for about a third of the Consumer Price Index. Gas prices are another big one. These are a few of the areas where the federal government could be trying to prevent this from happening to begin with.
Second: We have to remember the Fed has been susceptible to political pressure in the past, when there was a powerful labor movement and a Democratic Party that had been forced to take labor seriously. Elected officials had to consider what the political reactions would be for each of their actions related to employment and inflation. And so, this means we could influence their decisions again. If we continue to organize, continue to build the kind of powerful movement, with both labor and community groups working in solidarity, we can build power we need to win more of our fights, we can perhaps once again be in a position where they have to take us seriously.

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