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Monetary policy became more difficult to characterize during and after the mortgage foreclose and financial crises because of a shift to a new credit policy focused on private sector credit and that relies on traditional commercial banking strategies. The new credit policy broke the tight link that had existed between Fed credit and its effective monetary base, the monetary base that affects monetary aggregates. The Fed has adopted an exit strategy, but the discretionary powers that it followed remain in place as does a mistaken policy on the payment of interest on excess reserves.

Monetary policy has become more difficult to characterize or follow since 2007. Before that time, matters were simpler, but still not simple. Earlier, there was a persistent debate about whether monetary policy was best characterized and understood as interest rate policy or by Federal Reserve (Fed) monetary actions to affect the growth rate of monetary aggregates. Since 2007, however, the Fed has been implementing policy actions aimed at the availability of Fed credit, especially private sector credit, as the key factor affecting the stability of financial markets, output, employment and prices. Monetary policy became credit policy in 2007 and has remained so since then. The tight link between Fed actions that change the money stock and those that affect the Fed's contribution to the stock of credit has been seriously degraded. At least for some time, there is no longer any simple measure produced by the Fed that can be taken as a benchmark for the Fed's actions to affect the economic expansion, the value of money (inflation), or financial stability. The Fed has attempted to frame its response to the recession and financial crisis as largely following the analytical framework of Milton Friedman. For example, Nelson (2011, p. 2) cites Bernanke (2004, p. 2), who observes, “Friedman's monetary framework has been so influential that, in its broad outlines at least, it has nearly become identical with modern monetary theory and practice.” Nelson argues that “An underappreciated aspect of the policy response is its consistency on many dimensions with the framework for financial and monetary policy suggested by Milton Friedman's body of work.” The argument and evidence in this article are strongly at odds with the Fed's view of its policy and Nelson's explanation of its consistency with the work of Milton Friedman. Nelson (2011) is characterized as a Fed view here, but this is not to argue that it was promoted or supported by research colleagues or Fed officials.1 Section 1 discusses conventional interest rate policy and monetary base control as methods to influence aggregate demand. The Fed largely abandoned conventional interest rate policy in 2007 when it began to move the target federal funds rate to a rate below 25 basis points, or near zero. The Fed also prompted confusion over monetary actions by creating large excess reserves that blurred the Fed's actions to influence monetary aggregates. Section 2 details the Fed's shift to credit policy, its shortcomings, and the breakdown in the link between Fed credit and the monetary base. Credit policy shifts the focus of Fed actions away from monetary policy and, instead, stresses a critical channel for direct placement of credit to distressed non-depository private financial firms and Government Sponsored Entities (GSEs) as the principal means for countering financial crises and recessions.2 This section also provides an analysis of the payment of interest on reserves and the cost of subsidized excess reserve holding. Section 3 reviews recent claims by the Fed that their actions can be viewed as consistent with Milton Friedman's framework for monetary policy. Section 4 provides a summary and conclusions.

Chairman Bernanke has asserted: “I grasp the mantle of Milton Friedman. I think we are doing everything Milton Friedman would have us do.” See Nelson (2011), based on Chan (2010). Yet, at least four of Nelson's claims of consistency with Friedman are in fact counter to the principles of central banking that he laid out.28 What is consistent with Friedman's work is the fact that setting a nominal interest rate target is not sufficient to control the real federal funds rate and his argument that the Fed is the principal cause of recessions. The day after his death, the Wall Street Journal published his last article. Friedman (2006) compared the path of money growth surrounding the Great Depression and the end of stock price bubbles in the early 1990s in Japan and in 2000 in the United States. He showed that cyclical downturns were predicted by slowing money growth and that the cyclical slowing was larger, the larger was the slowing in money growth. The sharp slowing in monetary base growth to an historical low in January 2008 reflects another such instance. Fed policy led to fluctuations in the real federal funds rate and the monetary base that slowed the recovery. During and after the foreclosure crisis, recession and financial crisis the Fed has followed a path that compromised the indicators used to assess policy and created serious new risks to the Fed and its ability to function in future. It adopted a credit policy that severed the link of Fed credit and the monetary base, created new subsidies that were costly and ineffective, and inflated the Fed's balance sheet with little or no effect on economic performance. These actions appear to be deliberate, as the Chairman of the Fed has long argued that the real effects of the financial fallout during the Great Depression independently contributed to it severity. In his view, targeted credit provision to distressed firms was the solution. Never mind the principle that failed firms should be closed to minimize effects on creditors, their customers and the economy. The evidence presented here shows that the Fed slowed the growth of the monetary base to recessionary levels by early 2006 and that it persisted in recessionary monetary base growth up until the beginning of the recession and well into the long recovery, delaying recovery and economic expansion. The evidence also shows that the Fed focused more on expanding private credit rather than expanding the monetary base and it complicated this approach by following a commercial banking model of private credit expansion. To implement this approach the Fed created new liability possibilities to expand excess reserves and supplementary Treasury deposit facilities and it reduced its traditional assets. None of these actions changed overall credit available directly and indirectly from the Fed and banking system to the private sector, but it did allow the expansion of the Fed's balance sheet and reduced credit available through depository institutions. The evidence shows that the explosion in the size of the Fed's balance sheet was not accompanied by effective monetary base expansion and therefore was not accompanied by stimulus to generate a typical quick recovery and expansion in economic activity. In the Fed's response to the financial crisis, furthering its credit policy, it has ended up with more than $1.5 trillion of excess reserves that it supports by a huge subsidy to depository institutions. The Fed would find that it is difficult to eliminate these excess reserves, should it desire to do so, because its balance sheet is heavily exposed to illiquid and risky long-term private sector assets and a predominately long duration portfolio of long-term Treasury securities. Legally, most of the Fed's new credit policy came about under the cover of Section 13(3) of the Federal Reserve Act. These asset powers should be eliminated or seriously tightened up by the Congress.29 Otherwise the Fed will conduct its future business in a similarly opaque, risky, and costly fashion in the next financial crisis, even if in fact it actually eliminates all of these new discretionary facilities and policies temporarily before then. It is well to recall that the shift to the new credit policy began well before the financial crisis, as a response to the mortgage foreclosure crisis and recession. In addition, the Congress could improve the management of reserves by outlawing the payment of interest on excess reserves, by ending the existing subsidy to banks for holding required reserves by mandating a discounted level of the rate paid on required reserves to a rate somewhat below the lesser of the Treasury bill rate and federal funds rate. Finally, the Congress could restrain the Fed's ability (and the Treasury's complicity) to act as a commercial bank by engineering Treasury deposits at the Fed (matched by artificial increases in Treasury debt) that could accommodate a further expansion of private sector lending by the Fed.