Summary of Papers Presented at the Second Conference of the International Research Forum on Monetary Policy

153 Summary of Papers Presented at the Second Conference of the International Research Forum on Monetary Policy Gregg Forte, of the Board’s Division of Research and INFORMATION AND LEARNING Statistics, prepared this article. In the conference’s first session, ‘‘Information and The International Research Forum on Monetary Learning,’’ two papers considered the conduct of Policy held its second conference on November 14 monetary policy during the high inflation and high and 15, 2003. The organization is sponsored by the unemployment (stagflation) of the 1970s. In both European Central Bank (ECB); the Board of Gov papers, the authors note the wide agreement today ernors of the Federal Reserve System (FRB); the that underlying productivity growth had fallen in the Center for German and European Studies (CGES), at early 1970s and that monetary policy was too accom Georgetown University, in Washington, D.C.; and the modative given the resultant narrowing of the output Center for Financial Studies (CFS), at the Goethe and unemployment gaps. Fabrice Collard and Harris University, in Frankfurt. It was formed to encourage Dellas create a model that can explain the conduct of research on monetary policy issues that are relevant monetary policy in the 1970s if the central bank is from a global perspective, and it organizes confer fairly insensitive both to expectations of rising infla ences that are held alternately in the euro area and the tion and to any perception of a wide output gap and is United States. also highly uncertain about potential output. The 2003 conference, held in Washington, D.C., Athanasios Orphanides and John C. Williams trace featured ten papers.1 Among the topics examined the high-inflation episode to monetary policy mis were the Great Inflation of the 1970s in the United takes that had started earlier, in the mid-1960s. They States and the influence of learning, or adjustment argue that, from the mid-1960s through the late of expectations, on policy outcomes; the tradeoffs 1970s, the Federal Reserve paid excessive attention between rules-based and discretionary monetary pol- to stabilizing output and employment around levels icy; the 1999 formation of the European Economic that later proved to have been too high. This policy and Monetary Union and whether it altered the degree mistake loosened inflation expectations and gave of economic integration between the United States rise to the stagflation of the 1970s. The authors and the euro area; the potential benefits of greater believe that the recognition of this error at the end of competition in the euro area; and optimal monetary the decade led policymakers to place greater empha policy in an international setting. This summary sis on the stabilization of prices and of inflation discusses the papers in the order presented at the expectations. conference.2 Note. The author of this article thanks Dale Henderson and the Collard and Dellas authors of the conference papers for their assistance in its prepara tion and Christopher J. Erceg, Glenn Follette, Christopher J. Gust, Daniel E. Sichel, and Robert J. Tetlow for helpful comments. In their paper, ‘‘The Great Inflation of the 1970s,’’ 1. The organizers of the forum’s 2003 conference were Ignazio Collard and Dellas evaluate three alternative expla Angeloni (ECB), Matthew Canzoneri (CGES), Dale Henderson nations of the loose policy of the 1970s: (FRB), and Volker Wieland (CFS). 2. A list of the papers appears at the end of this article along with an alphabetical list of authors and their affiliations at the time of the Federal Reserve Board’s International Finance Discussion Papers conference. For a limited period, the papers will be available at (www.federalreserve.gov/pubs/ifdp/2004/default.htm), the European www.federalreserve.gov/events/conferences/irfmp2003/default.htm. Central Bank’s Working Paper Series (www.ecb.int/pub/wp/wp.htm), In addition, a revised version of each conference paper will be and the Center for Financial Research’s CFS Working Paper series available in one of the following series of working papers: the (www.ifk-cfs.de/English/homepages/h-cfsworkingpaper.htm). 154 Federal Reserve Bulletin Spring 2004 1. Policy was biased toward creating inflation sur recession and in its requirement of a very large prises as a means of lowering unemployment (or shock. ‘‘policy opportunism,’’ for short) The authors also examine the performance of the 2. Policy reacted strongly to increases in expected model under perfect information and a specification inflation but suffered from erroneous information of the Henderson–McKibbin–Taylor rule that con that hid the actual drop in underlying productiv tains a reaction to inflation that is too weak and thus ity growth and hence in potential output; thus, leads to indeterminate equilibriums. This specifica policy was only inadvertently loose (‘‘imperfect tion also performs quite well: It generates a large and information’’) persistent increase in the inflation rate after a large 3. Policy reacted weakly to increases in expected productivity slowdown (a supply shock of about inflation (‘‘weak reaction to inflation’’) 12 percent) and predicts an amount of macroeco nomic volatility comparable to that observed in the The authors employ a New Neoclassical Synthesis real world. The main weakness of this specification model, specified to produce a unique equilibrium, is, again, its exaggeration of the severity of the pre in which policymakers follow a standard Henderson– dicted recession. McKibbin–Taylor rule to set the policy rate. Finding The results from these two specifications suggest the conditions under which such a model will gen that one need not appeal to the first explanation erate the 1970s volatility in inflation and in other (policy opportunism) to explain the inflation of the macroeconomic variables such as output and invest 1970s. The results also suggest that it may not be ment, the authors say, may indicate which of the possible to discriminate between the second expla policy explanations is most relevant. nation (substantial imperfect information plus In the monetary policy rule, the policy variable set strong reaction to expected inflation) and the third by the authority in the present period is a function (good information but weak reaction to expected of three other variables: the policy variable in the inflation)—the data lend considerable support to preceding period, the inflation gap (the gap between both. The third explanation implies that economic inflation expected in the next period and the steady- outcomes would have been much better had the state rate), and the output gap (the gap between central bank’s reaction to inflation been stronger, current output and potential output). Potential output whereas the second explanation implies that, given is not observable, and the monetary authority learns uncertainty about the true output gap, even a strong only gradually about shocks to it. reaction to inflation would not have sufficed to keep In looking for a specification of their model that inflation in check in the face of a very large, unob will reproduce the conditions of the 1970s, the served productivity slowdown. authors vary the shocks to, and the degree of uncer tainty about, potential output and the speed at which the monetary authority responds to changes in the Orphanides and Williams inflation gap and the output gap. In the first (baseline) trial, the authors assume a reaction speed about the In ‘‘The Decline of Activist Stabilization Policy: same as that commonly associated with the Volcker– Natural Rate Misperceptions, Learning, and Expec Greenspan era, that is, a coefficient of 1.5 on the tations,’’ Orphanides and Williams reexamine the inflation gap and 0.5 on the output gap. (A value sources of U.S. stagflation in the 1970s and of of at least 1 for the coefficient on the inflation gap the subsequent improvement in macroeconomic is necessary for the model to avoid an indetermi performance. nate equilibrium—that is, the possibility of reaching The authors trace the policy failure of the 1970s to various stable but undesirable economic outcomes.) what they term the ‘‘activist’’ approach to macroeco They select a supply shock—a reduction in produc nomic policy—the so-called New Economics, which tivity growth—sufficient to generate an increase of became popular during the 1960s. According to this 5–6 percentage points in the inflation rate. They find approach, the management of aggregate demand that with a supply shock of about 30 percent and a could counteract any shortfalls or excesses relative to high degree of uncertainty about the output gap, the the economy’s potential and thus attain the dual goals model produced the desired increase in inflation. of macroeconomic policy: sustained prosperity and Moreover, this specification is quite successful in price stability. The enviable performance of the U.S. predicting the volatility in variables such as invest economy in the first half of the 1960s appeared ment, output, and inflation. Its main weakness is to validate the promise of the New Economics. But in its exaggeration of the severity of the predicted in the second half of the 1960s, the prosperity was Second Conference of the International Research Forum on Monetary Policy 155 purchased at the cost of rising inflation; and by the increases in oil prices and the productivity slowdown 1970s, the economy had fallen into stagflation—high during that period. According to the model, a less unemployment accompanied by high inflation. aggressive reaction to the unemployment gap would Orphanides and Williams argue that in the 1960s have done a better job of stabilizing inflation and and 1970s the Federal Reserve attempted a tight unemployment in the 1970s. stabilization of the unemployment rate near an esti By end of the 1970s, according to the authors, mate of the natural rate that was far too low. The monetary policy makers appeared to recognize the resulting gradual rise of inflation adversely influ nature of the problem.

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