In the middle of a depression in 1920, NY Fed and a few other Reserve Banks raised interest rates. To us it looks like a policy error, because macroeconomic theory says you should loosen in downturns. So it is tempting to say “they were ignorant.” But a better explanation is to

acknowledge that based on the economic theory central bankers back then held what they did was rational. Policymakers believed that banks would start lending only when they paid back their (rediscount) debt to the Reserve Banks. By increasing rates they were speeding up this

process. The quicker banks got out of being indebted to the Fed, the quicker they would resume lending. It makes a lot of sense if you consider that policymakers were bankers themselves and didn’t have macroeconomic data that would show them the countercyclical effects of policy.

By 1926, however, those at the NY Fed had come to understand the counter-cylical effects of open market operations (OMOs) on both credit and economic activity. How was this possible in the absence of macroeconomic theory and data?

The answer lies in the centralization of OMOs

in a committee controlled by the NY Fed in the early 1920s. Once you centralize OMOs in and execute them from one location, you can actually start seeing the cause-effect relationships both in the NYC money market and through the Reserve accounts that banks keep at NY Fed.

Since NY banks are at the heart of the banking system, account manager at the Fed can simply observe how movement of funds to different sectors and regions correlate with interest rates in the money market. This means now you have a position from which one can govern these flows.

And this is the most beautiful part: How does one manipulate these flows? By taking advantage of the tendency of banks’ reluctance to stay indebted to the Fed. Because you know they will pay debt back at the discount window if you lend them money in the open market, OMOs create

the conditions necessary for the banks to increase their lending to other banks and/or sectors.

“The reluctance to stay indebted to the Fed” is of course the effect of the disciplinary actions of the Fed itself at the discount window. Ironically, after the Continental rescue in 1984, this reluctance turned into such a stigma that the Fed had to rethink its approach to OMOs