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 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 ’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 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 needed to regain its credibility as an tiative. It was recognized that the new plan had inflation fighter; second, the need to minimize to break dramatically with established practice, the cost of disinflation by convincing markets allow for the possibility of substantial increases quickly that the new procedures would be effec- in short-term interest rates, yet be politically tive; and third, the desire to make the necessary acceptable and convince financial markets partici- disinflationary policy actions more automatic pants that it would be effective. The new operat- and less dependent on the meeting-by-meeting ing procedures satisfied these conditions and were policy decisions of the Committee. Axilrod agrees adopted for the pragmatic reason that they would that making aggregate reserves the operating likely succeed. instrument and tying policy more closely to the An element not suggested by the historical evi- money supply accomplished these aims. dence as being important for the reform was mone- tarist ideology. According to Lindsey, Orphanides, and Rasche, the “monetarist experiment” of THE POLICY DEBATE SINCE October 1979 was “not really monetarist!” Indeed, after examining various alternative frameworks, OCTOBER 1979 including monetarism; new, neo, and old- In his contribution, Marvin Goodfriend fashioned Keynesianism; and nominal income reviews the evolution of monetary policy theory and inflation targeting, the authors conclude that and practice over the past 25 years and examines the Committee’s actions cannot be easily identi- how both theory and policy have been shaped fied with any of them. Rather, they interpret the by the earlier experience of the Great Inflation evidence as suggesting that in October 1979 the and the reform of October 1979. A large part of Committee simply accepted that, under prevailing this story, he writes, is that central bankers and circumstances, controlling monetary growth pre- academic economists learned from each other sented a robust approach to taming inflation and and both learned from the historical experience adopted the new operating procedures because with inflation and disinflation. of its determination to achieve that objective. Goodfriend points out that much of the macro- In his discussion, Stephen Axilrod suggests economic theory developed before October 1979 that the appointment of Paul Volcker as Chairman, remains at the core of policy models used today— specifically his unique contributions to the policy including elements such as the discrediting of the environment, deserves greater attention for under- notion of a permanent trade-off between inflation standing the events of October 1979. While infla- and unemployment and the importance of expec- tion would surely have been tamed eventually, tations for understanding inflation dynamics. He

FEDERAL RESERVE BANK OF ST. LOUIS REVIEW MARCH/APRIL, PART 2 2005 141 Orphanides and Thornton notes, however, that there was much less consen- its intentions for monetary policy. Goodfriend sus regarding some of these elements a quarter- also identifies and briefly reviews some open century ago than there is today. questions relating to monetary policy practice, The experience of the 1970s, and the ensuing such as whether the Federal Reserve should adopt lessons, shaped importantly some of the policy an inflation target and the extent to which FOMC choices, strategy, and tactics during and after the communications could be further refined. disinflation. As a result of the high and volatile Goodfriend identifies the modern New inflation at the beginning of the disinflation in Neoclassical Synthesis or New Keynesian model October 1979, Goodfriend suggests that the as the consensus model for monetary policy analy- Federal Reserve experienced a “loss of room to sis at present; however, he identifies a number of maneuver”; that is, it lost the leeway to choose continuing controversies regarding the consensus between stimulating employment and fighting model that remain unresolved. inflation over the business cycle. In essence, the In discussing the paper, Laurence Ball Federal Reserve was perceived by the public as expresses his agreement with parts of Goodfriend’s having lost its resolve to combat inflation. As a discussion but also the view that the consensus consequence, inflation expectations were driven model used to analyze monetary policy is flawed by recent experience, rather than being anchored and not likely helpful for understanding the policy by the Federal Reserve. Containing inflation in success of the Federal Reserve relative to other such an environment is much more difficult. central banks over the past 25 years. Ball is par- Goodfriend cites the recurrence of “inflation ticularly critical of the model’s formulation of scares” for several years following the October the Phillips curve and the emphasis on expecta- 1979 reform as evidence that regaining credibility tions in Goodfriend’s analysis. Regarding the was a gradual and costly process and identifies Phillips curve, Ball argues that some of the empir- the successful practice of preemptive tightening ical implications of Goodfriend’s consensus model as a means to combat such inflation scares as an are counterfactual and that the accelerationist important lesson from that experience. This suc- Phillips curve, which lacks any explicit role for cess, Goodfriend argues, was the key to restoring expectations, may provide a better characteriza- the Federal Reserve’s ability to stimulate employ- tion of the empirical evidence. Given his disagree- ment during downturns without compromising ment with the Goodfriend paper regarding the price stability. importance of gaining credibility and anchoring Indeed, perhaps the most important lesson expectations, Ball also investigates alternative from the experience of the past quarter-century explanations for why U.S. monetary policy has identified by Goodfriend is that success in stabiliz- been relatively successful in the past quarter- ing inflation and in anchoring inflation expecta- century. tions, with an explicit commitment by the central bank to pursue and maintain price stability, improves the stability of both inflation and output. LESSONS AND REFLECTIONS With regard to modern policy practice, In after-dinner remarks, John Taylor reviewed Goodfriend identifies three developments as the international implications of the 1979 reform. most important. First has been the rise of what he In his view, the October 6 reform was a critical terms implicit inflation targeting as the core of step in restoring stability not only in the United the Federal Reserve’s policy strategy. Second is States but around the globe. Knowledge and key the increase in policy transparency, specifically lessons from the U.S. experience spread around the Committee’s practice of announcing its target the world, leading to salutary shifts in monetary federal funds rate immediately following each policy in numerous other countries that had FOMC meeting. Third is the broader increase in experienced high inflation and instability during transparency in communicating the Committee’s the 1970s. As a result of these improved policies, concerns and providing information regarding reductions in the variability of both inflation and

142 MARCH/APRIL, PART 2 2005 FEDERAL RESERVE BANK OF ST. LOUIS REVIEW Orphanides and Thornton output have been noted in the United States and an institutional environment favoring central several other countries. bank independence, more systematic monetary The conference concluded with two panel policy with improved communications, and discussions. In the first, Ben Bernanke, Alan greater transparency were mentioned as factors Blinder, and Bennett McCallum addressed the conducive to good policy practice. The critical question “What Have We Learned Since October role of leadership for successful policymaking 1979?” In the second, Roger Ferguson, Charles was also stressed. Goodhart, and William Poole discussed the issue Included in this volume are also ten personal of “Safeguarding Good Policy Practice.” Inevitably, reflections contributed after the conference, pre- the two panels overlapped somewhat and partici- senting different perspectives of the events of pants noted that identifying and safeguarding October 6, 1979. Anna Schwartz and Benjamin the salient characteristics of good policy practice Friedman revisit the academic debate surround- depends sensitively on the lessons drawn from ing Paul Volcker’s policy reform and assess the the improved policy environment of the past aftermath of the monetarist controversy that sur- quarter-century over that prevailing before the rounded the reform. reform of 1979. Perhaps the most frequently cited Together with Charles Goodhart’s comment, lesson was the recognition of the profound impor- the essays by Charles Freedman, Otmar Issing, and tance of low and stable inflation for maintaining Georg Rich offer a glimpse of the global climate economic prosperity and the central bank’s during the period and as seen by officials at unique responsibility to attain this goal. Panelists other central banks. Lastly, Robert Black, Philip also stressed the importance of credibility in Coldwell, and Frederick Schultz offer first-hand central banking and the benefits associated with accounts of the policymaking environment during well-anchored inflation expectations for enhanc- the turbulent period surrounding the reform; ing a central bank’s flexibility to stabilize real Edwin Truman and Joseph Coyne complement economic activity. An improved understanding this insider view with their perspective from the of the macroeconomy, better ideas and models, Federal Reserve trenches.

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