The Lost History of Volcker-era Monetary Policy
Its as close to a test of modern macro theory as we have. We thought if we shrank the growth rate of the money supply we would get a recession but we also lower the rate of inflation. That’s exactly what happened.
This is the bedtime-story of the Volcker era. However, it may not fit the facts. More below the fold.I was an economist at the Fed at the time, starting in July of 1980. Paul Volcker had become Fed Chairman in August of 1979. As Carl E. Walsh’s retrospective explains,
on October 6, 1979, the Federal Reserve adopted new policy procedures that led to skyrocketing interest rates and two back-to-back recessions but that also broke the back of inflation and ushered in the environment of low inflation and general economic stability the United States has enjoyed for nearly two decades.
Again, the bedtime story. But Walsh refers to a paper by David E. Lindsey, Athanasios Orphanides, and Robert H. Rasche (LOR) that is more nuanced.
LOR point out that at the time, prominent monetarists, such as Allan Meltzer, did not believe that the October 6 operating procedures would work. The monetarists pointed out that the new operating procedures did not really target money. Instead, the Fed set a target for “non-borrowed reserves.” There was widespread suspicion that the Fed had not really abandoned its focus on the Federal Funds rate as its target. But it wanted more freedom to increase the target without calling attention to each increase as a policy move. “Non-borrowed reserves” acted as a kind of smokescreen, behind which these increases in interest rates could be hidden.
The Lindsey paper argues that the Taylor rule fit the pre-Volcker data as well as the post-Volcker data. They write,
the tendency of a standard forward-looking Taylor rule to predict a funds rate from early 1976 through mid-1979 that not only exhibited fairly subdued movements but also came reasonably close to the actual funds rate set by the FOMC…[this] highlights the fragility of supposedly efficient Taylor-rule prescriptions. The strategy of exact adherence to this rule would not have delivered much better outcomes than the policy in place before the reforms of October. And adherence after October 1979 would have prevented the tightening necessary for controlling inflation.
LOR point out that Chairman Volcker himself was extremely skeptical about the stability of the relationship between money growth and GDP, particularly in the short run.
Chairman Volcker. . . . I would remind you that nothing that has happened–or that I’ve observed recently–makes the money/GNP relationship any clearer or more stable than before. Having gone through all these redefinition problems, one recognizes how arbitrary some of this is. It depends on how you define [money].
LOR hasten to add that the Chairman was not a closet nominal-income targeter.
nominal income targeting would not have represented as stark a break from the gradualist policies of the past as the Committee must have felt was necessary. As described by Tobin, and in light of the policy lags involved, nominal income targeting would require the central bank to continue to fine-tune the stance of policy on the basis of predictions of the future, hardly a recipe for success given the profession’s sad forecasting record earlier in the 1970s
What one comes away with is the impression that Chairman Volcker simply had a stronger preference for price stability (not just inflation stability) than just about any other prominent public official or economist, and he was very determined and very powerful in pursuit of his goals.
Some things that these retrospectives leave out that I remember.
1. The role of the Reagan tax cuts in prolonging the period of tight money. Many economists, both inside and outside the Fed, were convinced that the large increase in the deficit would unleash strong inflationary pressures. Interest rates were kept high in the hopes of neutralizing this inflationary surge. In fact, what ensued was unexpected weakness–either a single long recession or a double-dip, depending on how you want to look at it.
2. The role of the “bond market vigilantes.” In a Sumnerian, rational-expectations world, the new operating procedures should have caused long-term interest rates to fall, as the markets anticipated lower inflation. In fact, bond markets seemed to be backward-looking with respect to long-term inflation expectations, and the higher short-term rates were simply added in to the expected long-term rate.
I think it is fair to say that high interest rates had something to do with the recession of the early 1980’s, and the recession had something to do with the slowdown in inflation. That makes the 1980’s contraction much more of a poster child for an aggregate demand story than for a recalculation story. But other issues are less clear.