In the pre-Volcker years, the Fed allowed real short-term interest rates to drift lower even as anticipated inflation rose.
Since the early 1980s, the U.S. economy has enjoyed the desirable combination of low inflation and sustained growth. Yet, in the 1960s and 1970s, the economy was battered by runaway prices and four recessions. What accounts for this striking difference in performance? Monetary policy is an important factor in explaining the economic divide, according to Richard Clarida, Jordi Gali, and Mark Gertler writing in Monetary Policy Rules and Macroeconomic Stability: Evidence and Some Theory (NBER Working Paper No. 6442).
Of course, many economists and investors agree that the Federal Reserve has done a fine job under the leadership of Paul Volcker and his successor, Alan Greenspan. A similar consensus exists that monetary policy was far from successful during the decade and a half before Volcker became Federal Reserve chairman in 1979. This paper delves into key differences in the way monetary policy was conducted pre- and post-Volcker. It then looks into whether a marked change in monetary strategy contributed to the dramatic shift in macroeconomic performance.
The primary difference in policy regimes involves the Fed funds rate, the rate of interest charged for overnight money and the principal instrument for conducting monetary policy. In the pre-Volcker years, the Fed allowed real short-term interest rates to drift lower even as anticipated inflation rose. True, the Fed did hike nominal interest rates, but often by less than expected inflation, say the authors. Thus, policy did not act to stabilize the economy which would have required real interest rates to rise in response to expected inflation.
In distinct contrast, during the Volcker-Greenspan era, the Fed has raised both real and nominal rates when the specter of higher inflation loomed. "Our results thus lend quantitative support to the popular view that not until Volcker took office did controlling inflation become the organizing focus of monetary policy," say the researchers.
But how does this change in Fed monetary policy rules affect the economy's stability or lack of it? The authors argue that one possibility is that self-fulfilling changes in expectations allowed for bursts in inflation and output in the pre-Volcker years. According to this view, individuals rightly anticipated that the Fed would accommodate a rise in expected inflation by letting short-term real rates decline. No longer. The monetary rules followed by the Fed under Volcker and Greenspan preclude any similar self-fulfilling fluctuations in economic activity. The Fed adjusts interest rates sufficiently to stabilize any changes in expected inflation.
-- Chris Farrell