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Home , Great Moderation, Stagflation

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FEDERALRESERVE From to the BY VANESSA SUMO

hen returned sent rates soaring to their How former early from an Inter- highest levels on record and triggered W national Monetary Fund two . But the move also meeting in Belgrade on Oct. 2, 1979, finally arrested ’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 . Chairman of the Federal Reserve The “Incredible Volcker Dis- Paul Volcker Board of Governors, had called for a inflation,” as 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 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 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 . 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 ’s resolve in pursuing stability. prices stable. PHOTOGRAPHY: GETTY IMAGES PHOTOGRAPHY:

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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 . 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 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 and G. William Miller, Volcker was a well- meant triggering a . 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. 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 . 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 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

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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 ’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 -off would involve targeting a significant the decision in favor of changing between inflation and 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. Moreover, procedures. of the Federal Reserve Board of insights from The Fed has at its disposal two Governors and David Lindsey, former- theory taught that forward-looking main approaches for conducting open ly of the Board, and Robert Rasche of agents cannot be “fooled,” so their market operations: It can target the the St. Louis Fed, was “the practical expectations and corresponding price of balances — the observation that a monetary authority actions reflect how they perceive rate — that banks hold at the Federal deliberately setting the funds rate monetary policy is conducted. Reserve. Or it can target the quantity would be unlikely to select the level Friedman also argued that because of those balances. The operational that it expected to induce that targeted inflation is mainly a monetary phe- shift that Volcker was proposing would money stock, because the implied nomenon — caused by excessive mean the Fed would stop directly tar- of the funds rate would increases in the — the geting the prices of reserve balances be more than the authority could cost of reducing inflation in terms of and instead aim at a specific level of stomach.” Because there was always a lost output would be much less severe “nonborrowed reserves.” Under the strong reluctance to let the funds rate than was previously thought. These plan, the Fed would target a level of rise too high, adopting the new rule ideas encouraged the Volcker Fed to balances that would fall short of would allow the Fed to fix its gaze on proceed with its decision to drasti- demand at the prevailing fed funds keeping the amount of money and cally alter its policy. rate, thus causing banks to bid up the credit in check while letting the fed The Fed hoped that this dramatic rate — accomplishing the same mone- funds rate attain the necessary level. shift would send a firm signal of tary policy goal but in a different way. its resolve to fight inflation and its However, and advantageously, this Rise of the Monetarists intention to return the economy to approach would mean allowing a much Taming inflation expectations was a more stable times. The question, wider range where the fed funds rate central objective in this policy experi- however, was whether the Fed could could settle. stick to this policy. Volcker In speaking about these himself had hinted that he two alternatives, Volcker The Fed Funds Rate and Inflation intended to use the new oper- The Fed aggressively raised interest rates in the early 1980s mentioned that changing ating procedure for only to control inflation, which had reached double digits. operating procedures had three or four months. But it occurred to him in the past: 20 would take much longer than “My feeling was that by put- 18 that to deliver a permanent ting even more emphasis on 16 decline in inflation. meeting the money supply 14 The first test of the targets and changing operat- 12 Volcker Fed’s determination ing techniques … and thereby to stabilize prices came on 10

changing psychology a bit, we ERCENT what Goodfriend identifies P 8 might actually get more bang as the “inflation scare” of 6 for the buck … I overstate it, December 1979 to February 4 but the traditional method of 1980. During this period, the 2 making small moves has in 10-year bond rate, an indica- 0 some sense, though not tor of inflation expectations, 1971 1973 1981 1975 1972 1974 1977 1976 1983 1967 1985 1978 1979 1982 1987 1970 1969 1984 1968 1986 completely, run out of psy- 1980 soared from 10.5 percent to chological gas.” The two Fed funds rate Inflation 12 percent. The inflation rate possibilities were put to a vote in February over the previous NOTES: The blue line represents the monthly effective from and the outcome was unani- January 1967 to December 1987. The red line represents the monthly year-on-year year was around 14.2 percent. mous — switch to the new percentage change in the consumer price . The shaded areas indicate recessions At the same time, there were operating procedures. The as determined by the National Bureau of Economic Research; December 1969 to indications that the economy November 1970, November 1973 to March 1975, January 1980 to July 1980, and Committee widened the fed July 1981 to November 1982. was weakening, which once funds rate band from 0.5 to SOURCES: St. Louis Fed’s Federal Reserve Economic Data (FRED) and the again put the Fed in a bind. 4 percentage points. Bureau of Labor Statistics But the Fed forged ahead

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with its tightening stance, and within alternative of a sour economy and three years earlier. Inflation had two weeks of the March 1980 FOMC an outright recession this year. So, begun to weaken in the spring of 1982 meeting, the fed funds rate shot up to maybe there’s a little tendency to and by that fall, inflation had slipped 19 percent. shrink back on what we want to do to around 5 percent, the long rates This aggressive tightening, how- on the inflation side. I don’t want to dropped by 2 percentage points since ever, would only restrain inflation shrink back very far; that is my general that summer, and the fed funds rate temporarily, partly because the Fed bias for all the reasons we have stated fell to around 9 percent from more felt compelled to ease the burden it in our rhetoric but don’t always carry than 14 percent in July. had created by allowing interest rates through on.” The Volcker Fed reverted to man- to go so high. After credit controls Still, nothing could stop long-term aging the fed funds rate more closely (annual ceilings on both direct lend- inflation expectations from climbing (targeting the price of balances ing and loan guarantees in federal higher, as they did when the 10-year instead of the quantity) and began programs) that President Carter put bond rate peaked to more than 15 taking a more accommodative stance in place plunged the economy into an percent in October 1981. Average in its treatment of the money supply. even deeper recession, the Fed loos- inflation for 1981 was running high at The recession ended in November ened policy, effectively moving the 10.4 percent. This second inflation 1982. Still, the Fed did not give into fed funds rate down to 9 percent by scare, say Goodfriend and King, was complacency and held the fed funds July 1980. a pivotal moment in U.S. monetary rate in the 8 percent to 9 percent By the fall of that same year the history “because it convinced the range through the first half of 1983, fed funds rate and the 10-year bond Fed that the cost of a deliberate even as inflation moved down to rate were around 13.25 percent and in 1981-82 was acceptable less than 4 percent by the end of 10.5 percent, respectively, roughly in light of the recurring recessions that year, largely because long-term where they had stood the year before. that would be needed to deal with interest rates were still hovering over This seemed to suggest that efforts to inflation scares in the future.” 10 percent. stabilize inflation in the past year had And true enough, despite evi- The battle was not yet completely not been so successful, perhaps dence that the economy was faltering won at this point, for there were still because the familiar pattern of go- and moving into another recession, some inflation scares that would test stop policy that had plagued the Fed’s the Fed was unwavering in its pursuit the Fed’s mettle. Nevertheless, the credibility had not yet been convinc- of stable prices. In the July 1981 hardest work had been done. ingly shaken off. FOMC meeting, Volcker once again Volcker’s monetary policy experi- reminded everyone of the ultimate ment established the credibility Staying the Course objective. “I haven’t much doubt in that the Fed sorely needed to The Fed tightened monetary policy my mind that it’s appropriate in sub- stabilize inflationary expectations. A again, just as the economy was recov- stance to take the risk of more time of unprecedented low inflation ering from the short 1980 recession softness in the economy in the short and steady economic activity has and the threat of increasing energy run than one might ideally like in ensued in the decades since the prices due to skirmishes in the order to capitalize on the anti- Volcker disinflation, a period which Middle East. The fed funds rate rose inflationary momentum to the has sometimes been called the to a near record high of more than extent it exists,” Volcker said. “That “Great Moderation.” Most observers 20 percent in December of that is much more likely to give a more agree that improved monetary policy same year. Though the FOMC knew satisfactory economic as well as since Volcker deserves much of the it was risking another recession, inflationary outlook.” credit for this era of stability. Volcker reiterated the importance of Finally in October 1982, Volcker Without a doubt, staying the course in a February 1981 announced the end of the new operat- and have benefited meeting, “We see the risks of the ing procedures that were put in place greatly from this legacy. RF

R EADINGS

Federal Open Market Committee Transcripts, 1979-1982. Goodfriend, Marvin. “The Monetary Policy Debate Since October Washington, D.C.: Board of Governors of the Federal 1979: Lessons for Theory and Practice.” Federal Reserve Bank of Reserve System. St. Louis Review, March/April, vol. 87, no. 2, part 2, pp. 243-262. Goodfriend, Marvin, and Robert King. “The Incredible Volcker Lindsey, David, Athanasios Orphanides, and Robert Rasche. Disinflation.” National Bureau of Economic Research Working “The Reform of October 1979: How It Happened And Why.” Paper no. 11562, August 2005. Federal Reserve Bank of St. Louis Review, March/April, vol. 87, no. 2, part 2, pp. 187-235.

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