A Reconsideration of Federal Reserve Policy during the 1920–1921 Depression

Criticism of the Federal Reserve Board for not advancing rates earlier in 1919 to halt a rampant inflation is seldom as severe or nearly as devastating as the criticism heaped upon it for not easing credit sooner during the sharp but brief depression episode of 1920–1921. After the collapse of prices in May 1920, the immediate goal of Federal Reserve policy was to prevent a widespread financial crisis by maintaining the liquidity of the banking system. Congress had created the Federal Reserve System for the specific purpose of preventing a recurrence of the financial panics that had plagued our pre-World War I monetary experience. In 1920 the Federal Reserve Banks succeeded in this task by making funds freely available at relatively high discount rates. Somewhat surprising is the fact that there was no liquidation of bank credit nor decline in the money supply during the first six months of the downswing. Loans at commercial banks continued to increase, and member-bank indebtedness continued to rise. The action taken by System officials probably warded off what might easily have been the worst financial catastrophe in our history. Unfortunately, the policy they pursued, though successful in preventing a banking crisis, was inimical to a quick recovery of business activity. Inventory decumulation, particularly in the agricultural sector, was hampered by a bumper harvest and a railway transportation bottleneck which was not eliminated until October.