NATIONAL BUREAU OF ECONOMIC RESEARCH
NATIONAL BUREAU OF ECONOMIC RESEARCH

U.S. Monetary Policy During the 1990s

"Each rise in the inflation rate was met by an even larger rise in the nominal interest rate. This kept the inflation rate from being volatile, for the more the Fed responds to inflationary pressures, the less problematic inflation becomes, and the less the Fed has to respond to later."

In U.S. Monetary Policy in the 1990s (NBER Working Paper No. 8471), NBER Research Associate Gregory Mankiw analyzes the degree to which the monetary policies of Federal Reserve Chairman Alan Greenspan were responsible for the American economy's remarkable performance in the 1990s. Mankiw readily applauds those policies, but places them in certain contexts so as to gain a fuller understanding of the economy's dazzling decade.

To begin with, Mankiw points out that the famously low inflation rate of the last decade was not unique. It was certainly a dramatic change from the 1970s and 1980s, but in fact the 1950s and 1960s were also marked by very low inflation rates. The notable difference in the 1990s that Mankiw finds is the much higher degree of inflation stability -- the rate being a third less volatile than in the 1980s and a quarter less volatile than in the 1960s.

This is significant because standard theory holds that the cost of incremental inflation rises with inflation itself. The cost of a steady 4 percent inflation, for example, is less than the average cost of inflation that fluctuates between 2 and 6 percent. In addition, a highly volatile inflation rate creates unnecessary risks for both debtors and creditors.

Mankiw also notes a concurrent stability in both economic growth and joblessness during the 1990s. Indeed, these rates were far less volatile than in any recent decade. Coupled with the stability of the inflation rate, Mankiw says most observers would conclude the monetary policymakers were doing an amazing job, and perhaps they were. But perhaps they were also lucky.

The Fed's job, Mankiw points out, is to respond to shocks to the economy in order to stabilize output, employment, and inflation. A demand shock, such as a stock market crash, pushes output, employment, and inflation in the same direction and therefore is relatively easy for the Fed to handle (lowering interest rates to increase the money supply). Supply shocks, such as a jump in oil prices, tend to be more complicated, fueling inflation and threatening recession and leaving the Fed the task of trading off between inflation stability and employment stability. Yet an examination of the 1990s indicates that, unlike in previous decades, large supply shocks were uncommon in the 1990s.

Good shocks in fact were more common than bad. The worst shock of the 1990s (the result of the Gulf War) was less than one-fourth as large as the worst shock of the 1970s, and for the rest of the 1990s no adverse food or energy shock ever topped 1 percent. The vaunted growth of productivity and technological advance of the 1990s, Mankiw says, also may be considered a good shock. Yet the average rate of productivity growth in the decade was not unusual. What was unusual was the smooth advance in technology (the "New Economy") throughout the decade, which might help explain the low volatility in other macroeconomic variables. In view of such data, Mankiw concludes, the macroeconomic success of the 1990s was attributable at least in part to some very good luck.

Also fortuitous was the behavior of the stock market, for not only were returns high but volatility was low, making the 1990s essentially the best time ever to be investing in Wall Street. Little evidence suggests the booming market played a large, independent role in monetary policy. Yet significantly, the bull market of the period preceded the acceleration of the productivity rate by several years, and the market can be a driving force of the business cycle. Both of these reasons may well have inspired some of the fine-tuning and good timing of monetary policy.

Good conditions aside, the author agrees the Greenspan policies were both innovative and successful. Each rise in the inflation rate was met by an even larger rise in the nominal interest rate. This kept the inflation rate from being volatile, for the more the Fed responds to inflationary pressures, the less problematic inflation becomes, and the less the Fed has to respond to later. The Clinton White House deserves credit, Mankiw says, for respecting the independence of the Fed in this regard. But the larger credit must go to the Greenspan policy itself.

Mankiw however sees cause for concern for the future, because he says the Greenspan policy has never been fully explained. Fed policy of the 1990s might well be described as one man's "covert inflation targeting" and otherwise keeping all options open. But the policy in fact has never been spelled out in any detail by the "famously opaque" Fed chairman. Mr. Greenspan's successor is going to be left with a legacy that amounts to little more than the principle of: study all the data carefully and then set the interest rates at the right level. That, Mankiw worries, is going to be very hard to build on.

-- Matt Nesvisky


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