RF Summer 2006v27 7/24/06 12:52 PM Page 2 FEDERALRESERVE From Stagflation to the Great Moderation BY VANESSA SUMO hen Paul Volcker returned sent interest rates soaring to their How former early from an Inter- highest levels on record and triggered W national Monetary Fund two recessions. But the move also Federal Reserve meeting in Belgrade on Oct. 2, 1979, finally arrested inflation’s insidious everyone sensed that something was rise and set the stage for a long period Chairman afoot. Volcker, the newly installed of prosperity in the United States. Chairman of the Federal Reserve The “Incredible Volcker Dis- Paul Volcker Board of Governors, had called for a inflation,” as economists Marvin special meeting on Oct. 6, which was Goodfriend of Carnegie Mellon tamed inflation 10 days ahead of the regularly sched- University (and former senior econo- uled Federal Open Market Committee mist at the Richmond Fed) and and changed (FOMC) gathering. Average inflation Robert King of Boston University had rocketed to 10.6 percent in the (and a visiting scholar at the monetary first eight months of 1979 from 7.6 Richmond Fed) hail this period, was percent in 1978. In September, infla- “incredible” because the Fed was able policymaking as tion soared to a high of 11.9 percent to successfully bring down inflation over the previous year. from a high of 13.5 percent in 1980 to we know it Worried about those trends, less than 4 percent in just a few years, Volcker believed that the Fed had to and to keep it low for the next two change its policies, sharply and deci- and a half decades. This was a remark- sively. He opened that fateful meeting able feat at a time when inflation with this observation: “We wouldn’t be seemed so well-entrenched in the here today if we didn’t have a problem.” economy and the costs of reducing it More than a quarter of a century were deemed very large. ago, the Federal Reserve took a dra- But Goodfriend and King also call matic turn in monetary policy that this period “incredible” because the “imperfect credibility of monetary policy” complicated attempts to dis- inflate the economy. Stubbornness of inflationary expectations frustrated the Fed’s efforts to bring down infla- tion permanently, even after Volcker’s policy shift in October 1979. The public’s deep skepticism of whether policymakers were serious about tam- ing inflation and whether they would stay the course made it extremely difficult for the Fed to earn the credi- bility that was necessary to effectively rein in prices. One of the Fed’s missions is to conduct monetary policy in the pur- suit of maximum sustainable growth. The Fed’s decisive moves to In many ways, The Reform of control inflation, beginning October 1979, as it has also come to in 1979, drew the attention of be known, has led to the recognition the public and media, which that the Fed can best achieve this goal had grown skeptical of the through its principal mission: keeping central bank’s resolve in pursuing price stability. prices stable. PHOTOGRAPHY: GETTY IMAGES PHOTOGRAPHY: 2 Region Focus • Summer 2006 RF Summer 2006v27 7/24/06 12:52 PM Page 3 Great Expectations the Fed. The perception that taming other) to 11.5 percent. There were Setting policy in the presence of high inflation would always take a backseat eight assents and four dissents, but and volatile inflation expectations is to efforts to combat a potential reces- three of these dissents actually came like navigating a ship in a fog — it is sion created the reputation that the from hawks who were disappointed at difficult for a central bank to see Fed could not credibly commit to the relatively small change and where it is headed, whether it has price stability. favored more tightening. When the been tightening or loosening too Board of Governors met afterward to much or too little, and so runs the risk The Monetary Policy Experiment decide on the discount rate (the rate of destabilizing the economy. An Inflation began its ascent in the at which the Fed lends to financial environment with stable inflation mid-1960s. From a low of 2.6 percent institutions), a half percentage step up expectations, on the other hand, a year from 1964 to 1968, inflation was passed with a 4-to-3 vote, this makes it easier to bring about changes rose to an average of 5 percent from time with all three dissents on the in real interest rates and thus carry 1969 to 1973, and 8 percent from 1974 dovish side. out monetary policy effectively. to 1978. By 1979, it had reached a high But because only the vote on the The Fed that Volcker inherited was of 11.3 percent. discount rate was immediately made utterly lacking in credibility. At the known to the public, markets inter- time, the notion that an expan- preted the strong dovish dissents as sionary monetary policy could a signal that the Fed would fore- permanently reduce unemploy- The Fed that Volcker stall any further increases in the ment was widely accepted and led interest rate. Moreover, the markets many to believe that running some inherited was utterly believed that Volcker’s ability to inflation was worthwhile. In time, fight inflation was in question since the public would come to expect lacking in credibility. it appeared that he was facing that the Fed would each time increasing opposition within the loosen money in order to stimulate Fed. The vote also seemed to the economy. But there was little Even before he took over the confirm the widely held idea that the understanding of how such expecta- Federal Reserve chairmanship from Fed would stop fighting inflation if it tions could feed into future wages and G. William Miller, Volcker was a well- meant triggering a recession. Some prices. Hence, there was little appreci- known inflation hawk. In an April 1979 analysts speculate that events may ation about the importance of FOMC meeting as president of the have unfolded differently had the mar- anchoring inflation expectations. Federal Reserve Bank of New York, he kets known that three of the four This led to a “go-stop” fashion of remarked, “[Inflation] clearly remains dissents on the fed funds rate vote monetary policy. In the “go” phase of our problem. In any longer-range or were actually by hawks who wanted the policy cycle, inflation would rise indeed shorter-range perspective, the more tightening instead of less. slowly as the Fed stimulated output inflationary momentum has been Nevertheless, the public’s belief and employment. By the time infla- increasing. In terms of economic sta- that the Fed would take a softer tion reached worrying levels, higher bility in the future, that is what is stance on inflation roiled commodity inflation expectations had already likely to give us the most problems markets. Daily futures prices for pre- seeped into the public’s pricing deci- and create the biggest recession.” cious metals such as gold and silver sions. Thus, an aggressive increase in In part because of these creden- rose sharply and turned disturbingly the interest rate would have been tials, President Carter appointed volatile as speculators rushed to needed to trounce inflation, but as Volcker as Chairman, ushering out hedge their positions against infla- Goodfriend points out, “There was a Miller after only 18 (widely perceived tion. The mania spread to most other relatively narrow window of broad as ineffective) months on the job. But commodities as well. public support for the Fed to tighten in August 1979 when he was finally After commodity futures prices monetary policy in the stop phase of sworn in, Volcker held back. In order spiked on Oct. 2, rumors surfaced the cycle.” to assure public support for taking a that a support program for the flag- This window opened when rising drastic measure to fight inflation, he ging dollar was on its way, sending inflation started to become a concern, would need to wait for a moment of traders skidding the other way, only but closed quickly when unemploy- crisis to arrive. to learn later in the day that the ment began to rise. “The tolerance for That happened sooner than rumor was unfounded. At this point, rising inflation and the sensitivity to expected. During the September 1979 Volcker knew that the need for recession meant that go-stop cycles FOMC meeting, the committee pro- a dramatic monetary policy shift became more inflationary over time,” posed a small increase in the federal had arrived. explains Goodfriend. As a result, the funds rate (the overnight rate at which Calling for a special FOMC meet- public began to lose confidence in banks borrow reserves from each ing, Volcker was determined to push Summer 2006 • Region Focus 3 RF Summer 2006v27 7/24/06 12:52 PM Page 4 a strong program to deal with the The cleverness of this simple plan, ment, pushed to the foreground by situation. At the meeting on Oct. 6, apart from the huge publicity that it Milton Friedman’s monetarist ideas. he presented the committee with created, was in taking off the Fed’s Friedman pointed out that adjust- two possibilities for attacking infla- hands the responsibility of where the ments in inflationary expectations tion: the traditional method that fed funds rate may go. What tipped would break the perceived trade-off would involve targeting a significant the decision in favor of changing between inflation and unemployment increase in the fed funds rate; operating procedures, according if monetary policy continued to or, a radical change in operating to economists Athanasios Orphanides exploit this relationship.