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Editors' Introduction Editors’ Introduction Athanasios Orphanides and Daniel L. Thornton n October 6, 1979, the Federal ensuing lessons of that period. It may be the most Reserve implemented a monetary fruitful and proper way to commemorate the policy reform of profound signifi- events of October a quarter-century ago.” cance for the U.S. economy, mark- Oing the beginning of the end of the inflationary malaise that permeated the economy at the time. ORIGINS OF THE GREAT Starting with its policy actions that Saturday INFLATION afternoon, the Federal Reserve reaffirmed its In the first conference paper, Allan Meltzer responsibility to restore and maintain an environ- offers a historical analysis of the economic and ment of price stability in the economy, thereby political forces that generated and sustained the restoring confidence and setting the stage for a Great Inflation of the 1960s and 1970s and period of lasting economic prosperity. This pros- necessitated the forceful disinflationary actions perity has been interrupted only by two mild and of October 1979. Various explanations have been shallow recessions over the past two decades. advanced as possible causes of the policy errors A conference held in St. Louis on October 7 of that period. Some are based on the political and 8, 2004, provided the opportunity to reflect business cycle and dynamic consistency problems on the history of monetary policy in the United relating to the limited independence of the Federal States 25 years after the events of that October. Reserve at the time from the political process. Over the two-day period, three papers were pre- Other explanations stress the role of misinforma- sented and discussed, followed by two panel tion or misinterpretation of economic theories, discussions revisiting and distilling the policy models, and/or data. lessons surrounding the events of October 1979 Meltzer reviews these explanations and dis- and those that can be drawn to safeguard good cusses their limitations in providing a complete policy practice going forward. This conference account of the historical experience. His analysis volume is a compilation of the conference pro- leads to his conclusion that not one but multiple ceedings as well as personal reflections commem- elements must be identified as critical to under- orating October 6, 1979. stand the policy errors of the 1960s and 1970s. With the passage of time, the significance of Meltzer stresses the role of leadership and beliefs that moment for our nation’s economic history and of Federal Reserve policymakers, particularly the continuing prosperity will surely fade. Nonethe- Chairman. According to Meltzer, during the 1960s, less, we hope that this conference volume will Chairman Martin placed excessive emphasis on help preserve the lessons from the October 1979 reaching consensus among Federal Open Market episode. As Chairman Greenspan noted in his Committee (FOMC) members before changing introductory remarks: “We should strive to retain policy, a factor that contributed to unfortunate in the collective memory of our institution the delays in taking prompt anti-inflationary action Athanasios Orphanides is an adviser in the Division of Monetary Affairs at the Board of Governors of the Federal Reserve System, a research fellow of the Centre for Economic Policy Research, and a fellow of the Center for Financial Studies. Daniel L. Thornton is a vice president and economic advisor at the Federal Reserve Bank of St. Louis. Federal Reserve Bank of St. Louis Review, March/April 2005, 87(2, Part 2), pp. 139-43. © 2005, The Federal Reserve Bank of St. Louis. FEDERAL RESERVE BANK OF ST. LOUIS REVIEW MARCH/APRIL, PART 2 2005 139 Orphanides and Thornton at the early stages of the Great Inflation, allowing tion of the dominant framework for policy analysis it to gather momentum. Second, adherence to from the 1950s to the late 1970s, but argues that, apparently flawed theories of inflation adversely during the Great Inflation, policymakers replaced influenced policy deliberations. Over many years, one bad model with another, thus failing to recog- disregard of the fundamental long-run relation- nize the actions needed to restore price stability. ship between money growth and inflation steered A major implication of Meltzer’s emphasis on analysis toward nonmonetary explanations of political constraints on Federal Reserve behavior, inflation. Meltzer argues that for many years according to Romer, is that the Federal Reserve Federal Reserve staff and policymakers denied understood that the policy actions of the late that inflation had either begun or increased: They 1960s and 1970s were inflationary. Citing fore- believed instead that inflation was the conse- cast errors made by the Federal Reserve staff at quence of transitory factors that did not require a the time, Romer argues that this may have not forceful policy response. Third, and perhaps most been the case. In her view, the policy change in important, the presence of institutional arrange- October 1979 simply represented the triumph of ments that stressed policy coordination between better ideas over worse ones. fiscal and monetary policy compromised the independence of the Federal Reserve during the 1960s and 1970s. This, according to Meltzer, hin- HOW AND WHY DID THE dered the Federal Reserve from taking timely and OCTOBER 1979 REFORM effective disinflationary action throughout the period and is arguably the most significant factor HAPPEN? in his analysis. Meltzer suggests that such political David Lindsey, Athanasios Orphanides, and factors importantly influenced the thinking of Robert Rasche offer a historical review of the both Chairmen Martin and Burns and argues that monetary policy reform, discuss the influences those two Chairmen held a rather restrictive view behind it, and gauge its significance. The authors of Federal Reserve independence. Meltzer notes lay out in detail the policy record from the start that bad luck, in the form of lower productivity of 1979 through the spring of 1980, drawing exten- growth starting in the mid-1960s, also contributed sively on the recently released transcripts of FOMC to the inflationary problem. Ultimately, however, meetings during 1979, Federal Reserve staff analy- Meltzer suggests that the inflationary problem sis, and other contemporaneous sources. They could not have persisted in the absence of the then examine the reasons behind the Committee’s other factors he identifies—importantly, the decision to adopt the reform and the communi- presence of flawed economic reasoning and the cations challenge presented to the Committee compromised independence of the Federal during this period. Reserve. The paper argues that the reform was adopted In her discussion of Meltzer’s paper, Christina when the FOMC became convinced that its earlier Romer agrees with many of the points in Meltzer’s gradualist strategy using finely tuned interest rate analysis but argues that his emphasis on the role moves and aiming to avert economic slowdowns of politics may be unwarranted. Instead, Romer had proved inadequate for fighting inflation and argues, the Great Inflation occurred primarily reversing inflation expectations. Throughout 1979 because both fiscal and monetary policymakers and leading to the October reform, the FOMC were constrained by the misguided economic faced a deteriorating inflationary outlook as well framework of the time. In her view, inflation per- as a deteriorating economic outlook. During much sisted during that period because policymakers of the year, Federal Reserve staff, private forecast- relied on flawed models of the economy. Romer ers, and policymakers projected that recession stresses that views regarding the economy were was about to start. Within the gradualist frame- not stagnant during this period but rather were work in place, such concerns suggested caution changing. She provides an outline of the evolu- against restrictive policy actions. As the year 140 MARCH/APRIL, PART 2 2005 FEDERAL RESERVE BANK OF ST. LOUIS REVIEW Orphanides and Thornton progressed, the Committee increasingly realized Axilrod stresses that the paradigm shift that took that its inaction led to a deterioration of inflation- place following Paul Volcker’s appointment in ary expectations and instability in financial mar- the summer of 1979 would not have taken place kets. The Committee decided to embark on a without him. Axilrod thought two characteristics tightening path as early as July 1979 within its not usually found in a leader were important. existing operating framework. The Federal First, Volcker could think beyond the bounds of Reserve’s move toward tightening was reaffirmed central bank practice of the day. Second, he was by President Carter’s appointment of Paul Volcker technically highly proficient and interested in the as Chairman of the Federal Reserve. However, operating details of implementing central bank financial markets’ reactions, especially following policies so that the Committee could have confi- the FOMC meeting on September 18, 1979, sug- dence in his leadership and ability to guide policy gested that the Federal Reserve’s resolve to tighten in a new complex environment. policy sufficiently remained in question. This rift Among the reasons for the policy change reinforced the new Chairman’s beliefs that more identified by Lindsey, Orphanides, and Rasche, drastic steps toward restoring confidence were Axilrod stresses three: first, how badly the Federal needed, and such plans were prepared at his ini- Reserve
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