View original document

The full text on this page is automatically extracted from the file linked above and may contain errors and inconsistencies.

M o n e ta ry-P o licy

Rules and the Great Inflation

A t h a n a s i o s O r p h a n id e s *

With the exception of the Great Depression
of the 1930’s, the Great Inflation of the 1970’s
is generally viewed as the most dramatic failure
of macroeconomic policy in the United States
since the founding of the Federal Reserve. Fol­
lowing the euphoria and apparent success of
stabilization policy during much of the 1960’s,
macroeconomic events during the 1970’s were
agonizing and perplexing. After all, this was
meant to be the “Age of the Economist” (Walter
Heller, 1966 p. 2); when the latest scientific
advances in macroeconomic theory, model
building, and forecasting were brought to bear
on policy decisions; when, having mastered op­
timization techniques, economic advisers could
rely on the tools of activist stabilization policy
to guide the economy to its “optimum feasible
path” (Herbert Stein, 1984 p. 171).
Judging from the dismal outcomes of the
decade, especially the rising and volatile rates
of inflation and unemployment, it is hard to
deny that policy was in some way flawed. But
how exactly? Did not the policymakers of the
1970’s make a systematic effort to guide the
economy to its noninflationary full employment
potential? This, after all, had been and remains
the underlying macroeconomic policy objective
of government policies in the United States
since at least the end of World War II. And were
not the policymakers of, say, the mid-1970’s, as
well-informed, well-reasoned, and distinguished
as their counterparts of, say, the mid-1950’s or
the mid-1990’s, when economic outcomes were
Retrospectively, policy choices during the
1970’s may appear unsystematic, myopic, and
even inconsistent with basic principles of what
macroeconomic models sometimes suggest is
good policy practice. The period if often cited
as a prime example of the dangers associated
* Board of Governors of the Federal Reserve System,
20th and C Streets, N.W., Washington, DC 20551 (e-mail: The opinions expressed
are those of the author and do not necessarily reflect views
of the Board of Governors of the Federal Reserve System.

with discretion. But were policy decisions truly
inconsistent with what “scientific” treatises in
macroeconomics identify with good policy
practice, even today? Building on analysis and
evidence I presented in a series of recent papers
(Orphanides, 1998, 2000a, b, 2001a). I argue
that, on the contrary, policy decisions during the
1970’s can be reconciled with the application of
a “modem” systematic, activist, forward-looking
approach. I review monetary policy during the
1970’s through the lens of a forward-looking
Taylor rule to outline the origins of this appar­
ent paradox and discuss some of its unpleasant
implications for the role of perceived method­
ological advances for policy design.
I. Activist Policy Rules

A forward-looking version of the familiar
Taylor rule serves as a useful organizing device
for describing activist monetary policy. Sup­
pose the policy objective is to maintain unem­
ployment at its full-employment noninflationary
level (i.e., the “NAIRU” [non-accelerating in­
flation rate of unemployment] or “natural” rate),
«*, and inflation around a target, 7r*. Let /
denote the federal funds rate (the policy instru­
ment), r* the “natural” real rate of interest, tt
the outlook for inflation, and u the outlook for
unemployment, all expressed as percentages
(and annual rates when applicable). Then,
(1) / = r* 4-


+ P( tt — 77*) + y(w* —u)

provides a prescription for the desired setting of
the federal funds rate in terms of the inflation
and unemployment “gaps.” I employ the “un­
employment gap” in place of the “output gap”
concept in the classic rule proposed by John B.
Taylor (1993), noting that Okun’s law implies a
close relationship between the two concepts. A
discussion based on the output gap concept is
presented in Orphanides (2000b, 2001a). Using
a coefficient of 3 in Okun’s law (see e.g., Robert
E. Hall and Taylor, 1997), the classic Taylor



rule corresponds to the parameter settings /3 =
y = 1.5 and 7r* = r* = 2.
Policy rule (1) captures key elements fre­
quently highlighted as reflecting good policy
practice: a strong systematic response to infla­
tionary developments in the economy, /3 > 1; a
countercyclical response to the business cycle,
7 > 0 (with higher values of y associated with
a greater policy activism); and in light of the
well known lags in the monetary transmission
mechanism, a forward-looking policy approach,
accommodated by using near-term forecasts of
inflation and unemployment as summary indi­
cators of the state of the economy. Indeed, ver­
sions of (1) have been shown to represent
“optimal” policy in simple models where a cen­
tral bank has a quadratic loss function in infla­
tion and unemployment (see e.g., Orphanides,
1998), and approximately optimal in several
more complex estimated models (see Taylor
[1999] for a useful survey).
II. Implementation Issues

Though remarkably simple in appearance,
implementation of a rule such as (1) is quite
complex in practice. Determining the appropri­
ate forecast horizon and response coefficients 0
and y is certainly difficult. Even assuming that
these are known (for example, by drawing on
historical experience or on econometric policy
evaluation), two sources of significant difficulty
and possible error remain. One arises from the
presence of possibly systematic errors in assess­
ments of the outlook of the economy. In imple­
menting the rule in real time, a policymaker
would need to rely on preliminary assessments
and forecasts of inflation and unemployment, 7/
and uf. By responding to these forecasts and
preliminary assessments instead of the actual
outcomes, which are obviously not known when
policy is set, the policymaker inadvertently re­
sponds to the errors,
= tt - 7/ and s u =
u — «f, and adds what could easily prove to be
a substantial element of noise to the policy
actions. The other source of error arises from
the pervasive ignorance associated with at­
tempts to quantify the notions of “natural” rates
of interest and unemployment in real time. Pol­
icy could be set with the presumption that these
natural rates equal r*p and w*p (their perceived
values) only to be discovered, perhaps many

MAY 2002

years later, that r* and w* (their true values)
would have been better guesses.
These difficulties have long been identified as
likely sources of error for activist countercycli­
cal policies. For example, Allan Meltzer (1987)
highlighted the unreliability of forecasts in this
regard. In addition, in his forceful critique of
policy activism, Milton Friedman (1968 p. 10)
noted that “[u]nfortunately, we have as yet de­
vised no method to estimate accurately and
readily the natural rate of either interest or un­
employment,” and this remains true today.
Surely, accounting for the role of errors in
assessments of the outlook and misperceptions
about the natural-rate concepts in a policy rule
such as (1) would appear crucial for useful
policy evaluation and design. Unfortunately, the
practice of describing optimal policies based on
the presumption that such errors are small, un­
important, or easily avoided is not uncommon.
Policy influenced by this practice can have par­
adoxical results. As Orphanides (1998) demon­
strated, for example, if policymakers adopt
policies perceived to be optimal under the naive
presumption that such errors are less important
than they actually are, they may inadvertently
induce instability in the economy—precisely as
warned by Friedman and Meltzer. Interestingly,
unless the presence of such unintended errors is
carefully accounted for, policy could retrospec­
tively appear flawed and unsystematic even
when it is set exactly in accordance to a rule
such as (1), and meant to be optimal. Thus,
retrospective policy evaluations can easily ob­
scure the true source of historical policy errors.
If persistent over a period of time, misper­
ceptions about natural rates and errors in assess­
ments of the outlook in a policy rule such as (1)
could also result in a significant deviation of the
average rate of inflation from the policymaker’s
objective. A useful thought experiment for
quantifying this problem is to translate system­
atic misperceptions into the implied distortion
of the policymaker’s inflation objective that
would preserve the same policy setting. Thus,
suppose policy during some period is set with an
inflation target 7r*, and perceptions r*p and w*p.
From rule (1), systematic misperceptions about
the natural-rate concepts (r* — r*p) and (w* —
w*p) and systematic errors in assessments of the
and eu, over a period of time, would
be equivalent to a policy free of misperceptions

VOL. 92 NO. 2

F ig u r e 1. I n f l a t io n F o r e c a s t s


O utcom es

F ig u r e 2 . U n e m p l o y m e n t F o r e c a s t s

but with the distorted inflation target, 7r*, such
(2 )

7T* — 7T*

(r* — r*p) + I

— y s u + y(w* —w*p)


Thus, estimates of the natural rates of interest or
unemployment that prove too low, forecasts
of inflation that are too optimistic, or fore­
casts of unemployment that are too pessimistic
all lead to policy settings equivalent to a policy
with an inflation target that appears inappropri­
ately high. For example, with /3 = y = 1.5,
forecasts of inflation and estimates of the natu­
ral rate of unemployment that are systematically
1 percentage point too low would each be
equivalent to a policy with a distorted inflation
target that is 3 percentage points too high. Such
errors become worse as y rises or j8 falls.
III. Misperceptions and Policy in the 1970’s

Next, I illustrate how policy such as sug­
gested by rule (1) that might otherwise have
been expected to provide good policy advice
could have instead contributed to the dismal
outcomes of the 1970’s. To capture, as well as
possible, perceptions in real time, when actual
policy decisions were made, I rely on forecasts
from the Greenbook, a document prepared by
Federal Reserve Board staff for the Federal
Open Market Committee before every regularly
scheduled meeting. (Specifically, I use forecasts
from the Greenbook prepared during the middle
month of any quarter, and when that is not
available, the last month. Christina D. Romer




O utcom es

and David H. Romer [2000] offer a detailed
discussion of the usefulness of Greenbook
Figure 1 compares forecasts of inflation as
prepared in real time from 1969:1 to 1979:2
with ex post outcomes as measured today. For
each quarter t, the figure shows the forecast of
the rate of change in the output deflator from
quarter t — 1 to quarter f + 3. As is evident,
these forecasts of inflation proved consider­
ably biased over this period. The average
error is about 1 percentage point. (I use cur­
rent data as a proxy for “truth” noting that
even the most recent historical estimates
could be subject to further revision and, pre­
sumably, improvement.)
Figure 2 compares corresponding forecasts
and ex post outcomes for the average rate of
unemployment over the current and next three
quarters and also presents an illustrative com­
parison of real-time and current estimates of the
natural rate. While the unemployment forecast
errors appear large at times (e.g., at the ends of
both recessions in the sample [vertical dashed
lines]), they are essentially unbiased. With re­
spect to red-time estimates of the “natural” rate
of unemployment, the figure presents some sug­
gestive evidence of a significant bias. The ex
post series shown represents the latest historical
estimates of the NAIRU constructed by the
Congressional Budget Office. The real-time es­
timate shown is the one-sided simple average of
the historical unemployment series which Hall
(1999), and others, suggest is a good estimate
for this nebulous concept. Though larger than 1
percentage point, the average bias shown in
the figure for w* likely underestimates the bias
in real-time policymaker perceptions. As noted
in Orphanides (2000a, b), key policymakers


MAY 2002

T a b l e 1— E s t im a t e d P o l ic y R u l e












Notes: Standard errors are given in parentheses.

__ ___L ___I
___I .

I __U I ___1 _
_ __ ___I ___I _

1969 1970 1971 1972 1973 1974 1975 1976 1977 1978 1979

F i g u r e 3. R e a l - T i m e a n d E x P o s t T a y l o r R u l e s

suggested that 4 percent was a reasonable esti­
mate of w* at the end of the I960’s. (However,
I have not been able to reconstruct the evolution
of real-time consensus policymaker views for
the period.) As is evident in the figure, the error
in the real-time assessments of the natural rate
of unemployment meant that for much of the
1970’s policy decisions were based on the in­
correct belief that the economy was operating
below its full employment potential, while the
opposite was true. These errors are similar to
the misperceptions seen in official estimates of
the output gap (Orphanides, 2000a, b). In addi­
tion, these errors and the errors in forecasting
inflation over the same period are likely to be
intimately related by a Phillips curve lurking in
the background.
The large misperceptions of the natural rate
of unemployment and inflation forecast errors
imply that real-time and ex post policy settings
based on a fixed parameterization of policy rule
(1) would differ significantly. Figure 3 presents
such a comparison for the classic Taylor rule
with the parameter settings /3 = y = 1.5 and
7r* = r* = 2. As can be seen, the two versions
suggest significantly different policy settings
throughout the period. Knowing the history of
the 1970’s, one would now prefer that policy
had followed the settings suggested by the ex
post rendition, which systematically points to­
ward tighter policy than was actually imple­
mented. Indeed, it is tempting to conclude that
the Great Inflation might have been avoided if
only policy had followed this retrospective ren­
dition of the policy rule. Of course, proper eval­
uation of the historical policy choices could
only be based upon comparison of actual policy
with the real-time rendition of the rule. As the
figure shows, this leads to the exact opposite

conclusion: The real-time rule yields policy
very similar to that actually pursued. Thus, had
this policy rule been followed during the
1970’s, economic outcomes would likely have
been similar to the actual history.
Another way to assess the nature of policy
during the 1970’s, is by estimating a policy rule
using real-time perceptions of the state of the
economy. Consider the following regression:
f, = P f t - 1 + (1 - P)(a + 0 ^ - J M + ■),.
This generalizes policy rule (1) to allow for
possible partial adjustment, p E [0, 1), as sug­
gested by Richard Clarida et al. (2000), Or­
phanides (2001b), and others. Table 1 presents
least-squares estimates of (3) using the real-time
forecasts shown in Figures 1 and 2. Figure
4 compares the predicted settings from this es­
timated rule with the federal funds rate. Note
that in (3), a = r* + tt*(1 — 0) 4- yu*.
Setting 7r* = r* = 2, for example, suggests
that policy during the period was consistent
with a perceived estimate of 5.1 percent for the
natural rate of unemployment, not unreasonable
for the period. These results confirm that policy
decisions during this period were essentially
indistinguishable from what might reasonably
be seen as “good” policy practice.
IV. Discussion

Close examination of policy during the Great
Inflation suggests that actual policy decisions
were consistent with application of a “modem”
systematic, activist, forward-looking approach
to policy. Policy was consistent with an infla­
tion target of 2 percent, which should have
safeguarded the goal of reasonable price stabil­
ity. Policy responded strongly to forecasts of
inflation and the unemployment gap, which
could have been reasonably expected to result in

VOL 92 NO. 2


F ig u r e 4 . A n E s t im a t e d R e a l -T im e R u l e

a high degree of economic stability. Policy was
meant to guide the economy to its “optimum
feasible path,” consistent with what some “mod­
em” research emphasizing activist policy design
would suggest would be the “optimal” strategy to
follow. Yet economic outcomes were disastrous.
An unpleasant observation is that the resem­
blance of actual policy during this unfortunate
episode to such a modem policy approach
was not accidental. The innovation during the
1960’s, as Heller (1966 p. 116) emphasized,
was that “modem economic policy . . . har­
nessed the existing economics—the economics
that has been taught in the nation’s college
classrooms for some twenty years—to the pur­
poses of prosperity, stability, and growth.”
Policy was heavily influenced by the latest per­
ceived methodological advances in businesscycle theory and stabilization policy. The latest
techniques on model-based policy design of­
fered the promise that an activist policy could
yield a high degree of economic stability with­
out compromising reasonable price stability.
This, unfortunately, proved too tempting to ig­
nore. Thus, as Stein (1984) recounts, a “gradu­
alist” approach to the emerging inflation
problem at end of the 1960’s appeared best for
guiding the economy to its “optimum feasible
path.” Consistent with the natural-rate hypoth­
esis, maintaining the unemployment rate slightly
above the perceived natural rate was meant to
be the optimal approach for restoring price sta­
bility. The “optimum feasible path,” of course,
became the Great Inflation. Accepting that this
activist policy was optimal, the policy disaster
of the 1970’s, could be attributed to bad
luck—an adverse shift in the “natural” rate of
unemployment that could not have reasonably


been expected to be correctly assessed for some
time. But a more fundamental flaw can be
readily identified: concentrating policy efforts
toward targeting the economy’s elusive full
employment potential. Paradoxically, had poli­
cymakers concentrated their efforts on safe­
guarding price stability alone, better outcomes
for both employment and price stability would
have been likely. As long as “we have as yet
devised no method to estimate accurately and
readily the natural rate” (Friedman, 1968 p. 10),
it would appear wise to simply accept that the
scope for stabilization policy remains limited.
Clarida, Richard; Gali, Jordi and Gertler, Mark.

“Monetary Policy Rules and Macroeconomic
Stability: Evidence and Some Theory.”
Quarterly Journal of Economics, February
2000, 115(1), pp. 147-80.
Friedman, Milton. “The Role of Monetary Pol­
icy.” American Economic Review, March
1968, 58(1), pp. 1-17.
Hall, Robert E. “Comment,” in John B. Tay­
lor, ed., Monetary policy rules. Chicago:
University of Chicago Press, 1999, pp.
Hall, Robert E. and Taylor, John B. Macroeco­
nomics, 5th Ed., New York: Norton, 1997.
Heller, Walter W. New dimensions of political
economy. Cambridge, MA: Harvard Univer­
sity Press, 1966.
Meltzer, Allan H. “Limits of Short-Run Stabili­
zation Policy.” Economic Inquiry, January
1987, 25(1), pp. 1-14.
Orphanides, Athanasios. “Monetary Policy Eval­
uation with Noisy Information.” Federal Re­
serve Board (Washington, DC) Finance and
Economics Discussion Series No. 1998-50,
October 1998.
______. “The Quest for Prosperity without In­
flation.” European Central Bank (Frankfurt,
Germany) Working Paper No. 15, March
______ “Activist Stabilization Policy and
Inflation: The Taylor Rule in the 1970s.”
Federal Reserve Board (Washington, DC)
Finance and Economics Discussion Series
No. 2000-13, February 2000b.
______ “Monetary Policy Rules, Macroeco­
nomic Stability and Inflation: A View from the



Trenches.” Federal Reserve Board (Washing­
ton, DC) Finance and Economics Discussion
Series No. 2001-62, December 2001a.
______ “Monetary Policy Rules Based on
Real-Time Data.” American Economic Re­
view, September 2001b, 97(4), pp. 964-85.
Romer, Christina D. and Romer, David H. “Fed­
eral Reserve Information and the Behavior of
Interest Rates.” American Economic Review,
June 2000, 90(3), pp. 429-57.
Stein, Herbert. Presidential economics. Wash­

MAY 2002

ington, DC: American Enterprise Institute,
Taylor, John B. “Discretion versus Policy Rules
in Practice.” Camegie-Rochester Conference
Series on Public Policy, December 1993, 39,
pp. 195-214.
______. “The Robustness and Efficiency of
Monetary Policy Rules as Guidelines for In­
terest Rate Setting by the European Central
Bank.” Journal of Monetary Economics, June
1999, 43(3), pp. 655-79.