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The GSEs: Where Do We Stand?
William Poole
This article was originally presented as a speech to the Chartered Financial Analysts of St. Louis,
St. Louis, Missouri, January 17, 2007.
Federal Reserve Bank of St. Louis Review, May/June 2007, 89(3), pp. 143-51.

ne of the Federal Reserve’s most
important responsibilities is maintenance of financial stability. The
job obviously, and sometimes dramatically, encompasses crisis response. However,
the very existence of a crisis, when one occurs,
often demonstrates a failure of some sort, on the
part of the firms involved, the government, or
the Federal Reserve. It would not be difficult to
cite examples of such failures.
Not long after coming to the St. Louis Fed
in 1998, I became interested in governmentsponsored enterprises, or GSEs. My interest arose
when I began digging into aggregate data on the
financial markets and discovered how large these
firms are. The bulk of all GSE assets are in the
housing GSEs—Fannie Mae, Freddie Mac, and
the 12 federal home loan banks (FHLBs). Using
information as of September 30, 2006—the latest
available as of this writing—these 14 firms have
total assets of $2.67 trillion; given their thin capital positions, their total liabilities are only a little
smaller. Just two firms—Fannie Mae and Freddie
Mac—account for $1.65 trillion of the assets, or
62 percent of all housing GSE assets. Moreover,
Fannie Mae and Freddie Mac have guaranteed
mortgage-backed securities outstanding of $2.82
trillion. Thus, the housing GSE liabilities on their
balance sheets and guaranteed obligations off

their balance sheets are about $4.47 trillion, which
may be compared with U.S. government debt in
the hands of the public of $4.83 trillion.
In what follows, I’ll confine most of my comments to Fannie Mae and Freddie Mac, where the
largest issues arise. My purpose is to make the
case once again that failure to reform these firms
leaves in place a potential source of financial
crisis. Although there is pending legislation in
Congress, a major restructuring of these firms and
genuine reform appear to be as distant as ever.
My initial curiosity about the GSEs was stoked
simply by the size of these firms. As I investigated
further, I became concerned about their thin capital positions and the realization that if any of them
got into financial trouble the markets and the
federal government would look to the Federal
Reserve to deal with the problem. As I worked
through the issues, I began to speak on the subject;
my first such speech was in October 2001 (Poole,
2001). I last spoke on a GSE topic two years ago,
before the St. Louis Society of Financial Analysts.
My title then was “GSE Risks” (Poole, 2005).
Given that the risks did not seem likely to disappear any time soon, about six months ago I settled
on a GSE topic once again.
Today I want to look back over the past few
years to summarize a few of the changes that have
occurred at the GSEs and in the regulatory envi-

William Poole is the president of the Federal Reserve Bank of St. Louis. The author appreciates comments provided by his colleagues at the
Federal Reserve Bank of St. Louis. William R. Emmons, senior economist, provided special assistance. The views expressed are the author’s
and do not necessarily reflect official positions of the Federal Reserve System.

© 2007, The Federal Reserve Bank of St. Louis. Articles may be reprinted, reproduced, published, distributed, displayed, and transmitted in
their entirety if copyright notice, author name(s), and full citation are included. Abstracts, synopses, and other derivative works may be made
only with prior written permission of the Federal Reserve Bank of St. Louis.

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ronment they face. It is no exaggeration to say
these have been event-filled years for the GSEs,
primarily because of disclosures of accounting
irregularities at Fannie Mae and Freddie Mac.
Although these firms stopped growing when the
irregularities were disclosed, I will emphasize
that once they get their houses in good order they
will likely resume rapid growth because of the
special advantages they enjoy in the marketplace
from their ties to the federal government. I remain
hopeful that Congress will eventually pass meaningful GSE reform legislation. Private sector financial firms ought to have an intense interest in
reform legislation. Still, given that there seems
to be so little appreciation of the importance of
the GSE issue, where do they—and we—go from
here?
Before proceeding, I want to emphasize that
the views I express here are mine and do not
necessarily reflect official positions of the Federal
Reserve System. I thank my colleagues at the
Federal Reserve Bank of St. Louis for their comments—especially Bill Emmons, senior economist,
who provided special assistance.

THE HOUSING GSEs SINCE
JUNE 9, 2003
Although the housing GSEs are less obscure
than they used to be, they are not much discussed
in recent months. A year ago I would have noted
that it was not unusual to find stories about the
GSEs on the front pages of major financial newspapers. They were the subject of substantial
debate in Congress and among financial policy
experts. They had escaped from obscurity, primarily because of publicity in recent years over
their accounting irregularities. But today they
seem to be returning to obscurity.
For Fannie Mae and Freddie Mac, the two
stockholder-owned housing GSEs, history can be
divided into two distinct eras—before June 2003
and after. June 9, 2003, was the day the board of
directors of Freddie Mac announced discovery
of significant accounting irregularities. The stock
prices of both Freddie Mac and Fannie Mae
plunged, as investors immediately realized that
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something might have gone terribly wrong with
both GSEs. Subsequent investigations by private
experts and public authorities confirmed the fears
of many investors and financial supervisors.
These giant, fast-growing firms had poor accounting systems and financial controls.
Because it is important for my analysis later,
keep in mind these facts: First, the effect of disclosure of accounting irregularities at Freddie Mac
on June 9, 2003, led to a decline of 16 percent in
Freddie’s stock price and 5 percent in Fannie’s
stock price that day. However, as I’ll document
later, the effect of these disclosures on the mortgage market was negligible. Similarly, when
Fannie’s accounting irregularities were disclosed
on September 22, 2004, its stock fell by 6.5 percent that day and by a total of 13.5 percent over a
three-day period; the mortgage rate was again
unaffected.
Fortunately for financial stability, the accounting irregularities at Freddie Mac had been
designed, as we later learned, to understate earnings by a total of about $9 billion over a period of
years. Thus, there was no question of Freddie Mac
defaulting on any of its obligations and immediately unleashing unpredictable effects on its
counterparties or the financial system. In 2004,
we learned that Fannie Mae’s accounting was
revealed to be faulty. In December 2006, Fannie
restated its earnings for 2002, 2003, and the first
half of 2004, revealing that it had overstated its
earnings by a total of about $6 billion.
Fannie and Freddie are supervised by the
Office of Federal Housing Enterprise Oversight,
or OFHEO. In both cases, OFHEO’s early response
to disclosure of the accounting irregularities was
to declare the enterprises “significantly undercapitalized” because their extremely high leverage makes uncertainty of any kind about the true
capital backing of their portfolios a risk to their
own safety and soundness, as well as the stability
of the financial system. Beginning in the first
quarter of 2004, OFHEO required Freddie Mac to
hold capital at least 30 percent above the statutory
minimum level; OFHEO imposed the identical
requirement on Fannie Mae in the third quarter
of 2005. In addition, OFHEO required the firms
to correct their accounting; undertake a thorough
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Poole

review of corporate governance, incentives, and
compensation; appoint an independent chief
risk officer; and refrain from increasing their
retained portfolios.
The stunning accounting irregularities at
Freddie Mac and Fannie Mae served as wake-up
calls both to the GSEs themselves and to the supervisory and legislative communities. Freddie Mac
fired virtually all of its top-level management
immediately in June 2003 and then, a few months
later, fired the new CEO it had hired to replace
the original disgraced CEO.1 Barely a year-and-ahalf later, Fannie Mae ejected its own top managers, who had repeatedly declared that, unlike
Freddie’s, its own books were clean. The boards
of both companies agreed to a series of governance
reforms designed to bring the GSEs into line with
other large financial firms. Hundreds of millions
of shareholder dollars were committed to rebuilding accounting and control systems at both firms.
Both firms agreed to restate earnings for the past
few years; so massive was this undertaking that
neither firm is current on its financial reporting.
Freddie did release its annual report for 2005 but,
according to its press release of January 5, 2007,
may revise its results materially for the first nine
months and the third quarter of 2006. Nor is
Fannie filing current reports. In December 2006,
Fannie filed its Form 10-K for 2004 with the
Securities and Exchange Commission (SEC).
Currently, investors in common stock or debt
obligations issued by both companies rely on
partial and incomplete information subject to
material revision.
The GSE accounting scandals constituted a
rude awakening for OFHEO and Congress. OFHEO
was caught napping at Freddie Mac but, to its
credit, then identified Fannie Mae’s shortcomings
on its own. Once alerted to the problems, OFHEO’s
tenacious investigations into wrongdoing at both
Freddie Mac and Fannie Mae spurred investigations by the SEC and the Department of Justice.
Congressional hearings were held, and GSE reform
legislation was passed in oversight committees
1

Freddie Mac’s board of directors had misjudged at first how deeply
ingrained the internal-control and governance problems were and
had hired the former CFO to become the new CEO.

F E D E R A L R E S E R V E B A N K O F S T. LO U I S R E V I E W

of both houses of Congress in 2004 and 2005,
although no final legislation has been enacted as
of this time. I’ll have more to say about reform
legislation later, because I think this is an important missing piece of the overall puzzle.
Meanwhile, the FHLBs—the “other housing
GSEs”—were enduring accounting and control
crises of their own. Two of the twelve FHLBs
signed written regulatory agreements in 2004 with
their supervisor, the Federal Housing Finance
Board (FHFB), to rectify portfolio risk-management
deficiencies. Then, in 2005, 10 of the 12 FHLBs
failed to meet their agreed deadline to register
their stock with the SEC. Like Fannie Mae and
Freddie Mac, all of the FHLBs restated their earnings for recent years; all have now returned to
timely filing of accounting statements.
So where do we stand? I would characterize
the current situation as a period of uneasy waiting.
The GSEs have grown much more slowly, and
they have been more reticent in public in recent
quarters than they had been during the pre-2003
decade. It appears that they want to pursue a lowkey strategy while memories of their accounting
and control failures gradually fade. Their aim,
apparently, is to return to the environment before
heightened scrutiny arose in 2003.

WHAT HAS BEEN ACCOMPLISHED:
ANALYSIS OF GSE RISKS
Although I think much more needs to be
done, it would be a mistake to believe that nothing
useful was done after severe accounting problems
surfaced in June 2003. In general terms, the most
important achievement is a much broader and
better-informed discussion of the risks to financial
stability posed by the GSEs.2 We were fortunate
that the GSE accounting and governance scandals
did not threaten the immediate solvency of the
enterprises and that the problems surfaced when
the economy and financial markets were strong.
I will point to six major contributions to the
public investigation into, and debate about, the
risks posed by the GSEs. There have been other
2

For a more detailed discussion of this topic, see Poole (2005).

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contributors, to be sure, but this list provides what
I think is a good overview of the issues and what
we have learned so far:
• a 2003 study by Dwight Jaffee of interest
rate risks run by the GSEs;
• a 2003 study by OFHEO of the potential
systemic risks posed by the GSEs;
• a series of testimonies and speeches by
Federal Reserve Board Chairman Alan
Greenspan;
• a series of research papers prepared by
Federal Reserve System staff members;
• the results of a Federal Reserve ad hoc
study group investigating counterparty
exposures and risks in the over-the-counter
interest rate derivatives markets;
• and an economic-capital analysis of
Fannie Mae and Freddie Mac prepared by
Kenneth Posner, an equity analyst at
Morgan Stanley.
These bullet points provide the flavor of some
of the recent work on the GSEs. The appendix to
this speech provides a brief summary of each of
these items and citations.
Considering these results as a whole, we have
learned a great deal in recent years about the way
the GSEs operate, the risks they are taking and
how they attempt to manage them, and what
effects the GSEs have on financial markets during
normal times as well as during periods of market
turbulence. Armed with this knowledge, lawmakers and policymakers are in a much better
position to make needed improvements in the
statutory and regulatory environment in which
the GSEs operate.

THE CASE FOR FUNDAMENTAL
REFORM
I continue to believe that the nation would be
well-served by turning the GSEs into genuinely
private firms, without government backing,
implied or explicit. If they bolster their capital,
they can function perfectly well as purely private
firms.
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A key issue for many is whether privatizing
Fannie and Freddie would raise mortgage rates
paid by borrowers. We now have some solid evidence on how the mortgage market would function if the housing GSEs became fully private
firms. A careful econometric investigation by
three economists at the Board of Governors last
year (Lehnert, Passmore, and Sherlund, 2006,
abstract) reached this conclusion: “We find that
GSE portfolio purchases have no significant
effects on either primary or secondary mortgage
rate spreads.” Put another way, the 30-year mortgage rate fluctuates in tandem with the rate on
10-year Treasury bonds and the spread over the
Treasury rate is not affected by portfolio purchases
by Fannie and Freddie.
Another approach to acquiring evidence on
the effects on the mortgage rate of mortgage purchases by Fannie and Freddie is to examine what
happened when their portfolios stopped growing
in the wake of disclosures of accounting irregularities. Those disclosures led OFHEO to impose
30 percent temporary surcharges on the firms’
required minimum capital levels. Freddie Mac’s
capital surcharge was imposed in January 2004,
whereas Fannie Mae’s capital surcharge became
effective in September 2004.3 To meet the higher
capital ratio, the two firms had to do some combination of raising new capital and reducing their
portfolios.
The retained portfolios of mortgages and
mortgage-backed securities (MBS) held by Fannie
and Freddie grew strongly in the years preceding
the OFHEO orders. For example, if we look at
year-end figures for 2002 and 2003, we see that
over the course of 2003 the two firms’ retained
portfolios grew by a net of 12.3 percent and, at
the end of 2003, they held 22 percent of outstanding mortgages on 1- to 4-family properties. Net
growth of their retained portfolios then stopped;
over the course of both 2004 and 2005, their total
portfolios of mortgages and MBS fell slightly. In
2006, their retained portfolios continued to
decline and by the end of the third quarter their
portfolios were below year-end 2005. Meanwhile,
the total market continued to expand. The com3

See www.ofheo.gov/media/pdf/capclass93004.pdf.

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bined market share of Fannie and Freddie fell
from 22 percent at the end of 2003 to 14 percent
at the end of the third quarter of 2006.
What happened to the mortgage spread when
the GSEs stopped accumulating ever-larger portfolios? Nothing. Because fixed-rate mortgages
are subject to prepayment risk, whereas the 10year Treasury bond is not, there is a degree of
variability of the mortgage spread. But if the cessation of the GSEs’ portfolio growth had made a
difference, it surely would have shown up in the
data. The annual average of the spread in 2003,
before the OFHEO orders that restricted Fannie
and Freddie’s portfolio growth, was 180 basis
points; the spread was 157 basis points in both
2004 and 2005.
Nor did we observe any sort of shock to the
market when the accounting irregularities at
Freddie were disclosed in June 2003. The spread
was 196 basis points in May 2003, 198 basis points
in June, and 196 basis points in July. Consider also
January 2004, when OFHEO imposed a capital
surcharge on Freddie. That month, the mortgage
spread was 159 basis points. The month before,
the spread was 161 basis points; the month after,
156 basis points. The OFHEO order applying to
Fannie came in September 2004. That month the
spread was 163 basis points; the month before,
159; the month after, 162.
Toward the beginning of my remarks, I noted
that disclosure of the accounting irregularities
did affect the stock prices of the two firms. Now
we see that there was no effect on the mortgage
market. The issue, clearly, is the profitability of
the firms and not effects on the mortgage market.
The effects of problems at Fannie and Freddie on
the mortgage market have been minimal because
the market contains many competent and wellcapitalized competitors that can readily pick up
the slack when other players stumble.
Financial firms throughout the economy
ought to have an intense interest in reforming
the GSEs. One reason is simply that banks and
other financial firms, and many nonfinancial
firms, hold large amounts of GSE obligations and
GSE-guaranteed MBS. I believe that many risk
managers simply accept that GSEs are effectively
backstopped by the Federal Reserve and the fedF E D E R A L R E S E R V E B A N K O F S T. LO U I S R E V I E W

eral government without ever thinking through
how such implicit guarantees would actually
work in a crisis. The view seems to be that someone, somehow, would do what is necessary in a
crisis. Good risk management requires that the
“someone” be identified and the “somehow” be
specified. I have emphasized before that if you
are thinking about the Federal Reserve as the
“someone,” you should understand that the Fed
can provide liquidity support but not capital.4
As for the “somehow,” I urge you to be sure you
understand the extent of the president’s powers
to provide emergency aid, the likely speed of
congressional action, and the possibility that
political disputes would slow resolution of the
situation.
There is a long-run issue that goes beyond
that of today’s systemic risk. The fact is that it is
very profitable for a firm to be able to borrow at
close to the Treasury rate, lend at the market rate,
and hold little capital. That is why the promise
of constraints on the portfolio growth at Fannie
and Freddie had a significant effect on their stock
prices. Any firm with such a privileged position
will want to extend its scope of operations. Over
the past 15 years, Fannie Mae and Freddie Mac
have grown much more rapidly than has the stock
of mortgages outstanding and, as a consequence,
now hold or guarantee a large fraction of U.S.
home mortgages. At the end of 1990, they held
in their portfolios 5 percent of the mortgages for
1- to 4-family properties; the share peaked at 22
percent at the end of 2003; and, at the end of the
third quarter of 2006, the share was 14 percent.
Given the powerful incentive Fannie and Freddie
have to grow, the systemic risk they pose to the
economy will also grow.
Once their current accounting problems are
fully resolved, Fannie and Freddie will want to
resume their growth. It is simply very profitable
to be able to borrow at close to the Treasury rate
and invest in mortgages while holding minimal
capital. Banks maintain capital ratios double or
more the ratios that Fannie and Freddie maintain.
Banks pay deposit insurance premiums to the
4

For a discussion of Federal Reserve emergency powers, see Poole
(2004).

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Federal Deposit Insurance Corporation, whereas
Fannie and Freddie pay no insurance premiums.
Assuming that the implied guarantee would, in a
crisis, lead to a federal bailout, U.S. taxpayers
bear the risk while the shareholders and managers
of Fannie and Freddie enjoy the profits. This situation encourages these firms to grow vigorously.
These two firms, however, cannot meet their
growth targets in the long run if they confine their
operations to conforming home mortgages. Their
interest in increasing the conforming mortgage
limit is clear. Moreover, in my opinion, it is
inevitable that they will look for ways to extend
their operations into new areas. They have that
clear incentive because of the implicit federal
guarantee they enjoy. For them to extend their
operations into market segments already well
served by existing private firms will not enhance
the efficiency of mortgage markets or reduce
costs to mortgage borrowers.
There are two possible ways to constrain the
operations of the GSEs to areas with a clear public
purpose. One is to end the implied federal guarantee so that Fannie Mae and Freddie Mac compete on an equal basis with other fully private
firms. The other is to place restrictions on the
size of their owned portfolios if they retain their
privileged position. Their owned portfolios should
be limited to mortgages held temporarily in the
process of securitization.
Absent complete privatization, or on the way
to it, Congress should strengthen the powers of
OFHEO or a successor regulator. OFHEO has
weaker powers than provided by law to the federal
bank regulators—the Office of the Comptroller of
the Currency, the Federal Reserve, and the Federal
Deposit Insurance Corporation. The GSE supervisory framework remains fragmented and weak,
as the GAO has pointed out on numerous occasions.5 Thus, structural change of the GSEs and
their supervision should be at the top of the reform
agenda. There is a glaring need for legislation to
clarify the bankruptcy process should a GSE fail.
At present, there is no process and no one knows
what would happen if a GSE becomes unable to
meet its obligations.
5

Most recently, the GAO criticized GSE oversight in Walker (2005).

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Freddie Mac and Fannie Mae both got into
trouble with accounting irregularities in part
because of the complexities under generally
accepted accounting principles for derivatives
positions and rules determining which assets
should be reported at market value and which
should be reported at amortized historical cost.
Sound risk management practices require that
GSE management base decisions on market values,
or estimates as close to market values as financial
theory and practice permit. The reason is simple:
Fannie Mae and Freddie Mac pursue policies
that inherently expose the firms to an extreme
asset/liability duration mismatch. They hold longterm mortgages and MBS financed by short-term
liabilities. Given this strategy, they must engage
in extensive operations in derivatives markets to
create synthetically a duration match on the two
sides of the balance sheet. These operations
expose the firm to a huge amount of risk unless
the positions are measured at market value.
Almost all the assets and liabilities of the
GSEs are either traded actively in excellent markets or have values that can be accurately measured by prices in such markets. For this reason,
the financial condition of the GSEs ought to be
measured through fair-value accounting and such
accounts ought to be the principal yardstick of
condition and performance.

CONCLUSIONS
Since the GSE accounting scandals emerged
in mid-2003, one thing has remained rock-solid:
The GSEs have continued to borrow at yields only
slightly higher than those of the U.S. government
and noticeably lower than those available to any
other AAA-rated private company or entity. In
other words, despite the vast recent accumulation
of knowledge about the significant risks run by the
GSEs, as well as their inability (or unwillingness)
to manage these risks, investors in GSE debt securities appear unmoved. Upon reflection, the lack
of market discipline evident during this crisis
period is striking—like a dog that did not bark.
This fact indicates to me that there still is a significant problem with the GSEs that needs to be fixed.
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The obvious answer to why the dog did not
bark is that the so-called “implicit guarantee”—
that is, the belief by investors that the U.S. government would not allow the GSEs to default on their
debt obligations—has not been removed. Indeed,
the talk of increased GSE regulation and the failure
of structural-reform legislation to become law
may actually have reinforced the belief of many
that, overall, the government is perfectly happy
with the situation as it is. The GSEs remain
politically powerful, if less strident than they
were a few years ago.
Three essential reforms are needed to eliminate the GSEs’ threat to financial stability. First
is a limit on their portfolio growth, second is an
increase in their minimal required capital, and
third is satisfactory bankruptcy legislation so that,
should the worst happen, federal authorities can
deal with the problem in an orderly way.
Freddie Mac apparently does not expect any
significant increases in constraints on its operations. Funds that could have been used to build
capital to better protect taxpayers have instead
been used to increase common stock dividends.
Freddie set a quarterly dividend of $0.22 in the
fourth quarter of 2002 and has increased the dividend every year since. As of the fourth quarter of
2006, the dividend stands at $0.50 per quarter,
more than twice its level four years earlier. Fannie
Mae cut its dividend in half in early 2005 to build
capital, but I’ll hazard a guess that once it starts
issuing regular financial statements the company
will increase its dividend rather than build capital further.
I began this speech noting that the Federal
Reserve has a responsibility to maintain financial
stability. That responsibility includes increasing
awareness of threats to stability and formation of
recommendations for structural reform. I do not
believe that a GSE crisis is imminent. However,
for those who believe that a GSE crisis is unthinkable in the future, I suggest a course in economic
history.

REFERENCES
Board of Governors of the Federal Reserve System
(Parkinson, Patrick and Gibson, Michael) and

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Federal Reserve Bank of New York (Mosser, Patricia;
Walter, Stefan and LaTorre, Alex). “Concentration
and Risk in the OTC Markets for U.S. Dollar Interest
Rate Options,” March 2005;
www.federalreserve.gov/BoardDocs/Surveys/
OpStudySum/OptionsStudySummary.pdf.
Emmons, William R. and Sierra, Gregory E.
“Incentives Askew? Executive Compensation at
Fannie Mae and Freddie Mac.” Regulation, Winter
2004, 27(4), pp. 22-28.
Frame, W. Scott and White, Lawrence J. “Fussing
and Fuming over Fannie and Freddie: How Much
Smoke, How Much Fire?” Journal of Economic
Perspectives, Spring 2005, 19(2), pp. 159-84.
Greenspan, Alan. “Regulatory Reform of the
Government-Sponsored Enterprises.” Testimony
before the Committee on Banking, Housing, and
Urban Affairs, U.S. Senate, April 6, 2005a;
www.federalreserve.gov/boarddocs/testimony/
2005/20050406/default.htm.
Greenspan, Alan. “Risk Transfer and Financial
Stability.” Speech at the 41st Annual Conference
on Bank Structure and Competition, Federal
Reserve Bank of Chicago, May 5, 2005b;
www.federalreserve.gov/boarddocs/speeches/
2005/20050505/default.htm.
Greenspan, Alan. Monetary Policy Report to the
Congress. Question and answer session after testimony before the Committee on Financial Services,
U.S. House of Representatives, July 20, 2005c.
Hancock, Diana; Lehnert, Andreas; Passmore, Wayne
and Sherlund, Shane M. “An Analysis of the
Potential Competitive Impacts of Basel II Capital
Standards on U.S. Mortgage Rates and Mortgage
Market Securitization.” Basel II White Paper No. 4,
Board of Governors of the Federal Reserve System,
April 2005.
Jaffee, Dwight.“The Interest Rate Risk of Fannie Mae
and Freddie Mac.” Journal of Financial Services
Research, August 2003, 24(1), pp. 5-29.
Lehnert, Andreas; Passmore, Wayne and Sherlund,
Shane M. “GSEs, Mortgage Rates, and Secondary

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Market Activities.” Finance and Economics
Discussion Series Working Paper 2006-30, Divisions
of Research and Statistics and Monetary Affairs,
Board of Governors of the Federal Reserve System,
September 2006; www.federalreserve.gov/pubs/
feds/2006/200630/200630pap.pdf; forthcoming in
Journal of Real Estate, Finance and Economics.
Office of Federal Housing Enterprise Oversight.
“Systemic Risk: Fannie Mae, Freddie Mac, and the
Role of OFHEO.” Report to Congress, February
2003; www.ofheo.gov/Media/Archive/docs/
reports/sysrisk.pdf.
Passmore, Wayne.“The GSE Implicit Subsidy and the
Value of Government Ambiguity.” Real Estate
Economics, Fall 2005, 33(3), pp. 465-83.
Passmore, Wayne; Sherlund, Shane M. and Burgess,
Gillian. “The Effect of Housing GovernmentSponsored Enterprises on Mortgage Rates.” Real
Estate Economics, Fall 2005, 33(3), pp. 427-63;
www.federalreserve.gov/pubs/feds/2005/200506/
200506pap.pdf.

Poole, William. Remarks presented to the panel on
government-sponsored enterprises, 40th Annual
Conference on Bank Structure and Competition,
Federal Reserve Bank of Chicago, May 6, 2004;
www.stlouisfed.org/news/speeches/2004/
05_06_04.html.
Poole, William. “GSE Risks.” Federal Reserve Bank
of St. Louis Review, March/April 2005, 87(2, Part 1),
pp. 85-92; http://research.stlouisfed.org/
publications/review/05/03/part1/Poole.pdf.
Posner, Kenneth. “Fannie Mae, Freddie Mac, and the
Road to Redemption.” Morgan Stanley Equity
Research, July 2005.
Walker, David M. “Housing Government-Sponsored
Enterprises: A New Oversight Structure Is Needed.”
Testimony before the Committee on Banking,
Housing, and Urban Affairs, U.S. Senate, April 21,
2005; www.gao.gov/new.items/d05576t.pdf.

Poole, William. “The Role of Government in U.S.
Capital Markets.” Presented before the Institute of
Governmental Affairs, University of California at
Davis, October 18, 2001; www.stlouisfed.org/
news/speeches/2001/10_18_01.html.

APPENDIX
Summaries of Recent Studies on GSE Issues
Jaffee (2003) Study of GSE Interest Rate Risk
Dwight Jaffee was one of the first to “peer through” the public disclosures provided by the GSEs
about the interest rate risks they incurred and how they managed them. Jaffee concluded that the GSEs
actually incurred significant interest rate and liquidity risks, despite their own characterization of such
risks as being minimal. Subsequent events and analysis have proven Jaffee correct.
OFHEO (2003) Study of Potential Systemic Risks Posed by GSEs
Even before the GSE accounting scandals broke, the GSEs’ safety-and-soundness supervisor had
prepared a study comprising scenarios in which the GSEs might contribute to systemic risk. Although
OFHEO concluded that the likelihood of one or both GSEs contributing to financial-system instability
was very small, the agency recommended to Congress that its (OFHEO’s) supervisory powers should
be enhanced to further safeguard the GSEs and the financial system.

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Public Statements by Chairman Alan Greenspan (2005a,b,c)
Federal Reserve Chairman Greenspan (2005a) rejected the idea of stronger GSE regulation in favor
of portfolio limits, stating that,
World-class regulation, by itself, may not be sufficient and, indeed, might even worsen the potential for
systemic risk if market participants inferred from such regulation that the government would be more likely
to back GSE debt in the event of financial stress…We at the Federal Reserve believe this dilemma would
be resolved by placing limits on the GSEs’ portfolios of assets.

Chairman Greenspan also drew attention to the strains the GSEs could place on the over-the-counter
interest rate derivatives markets due to their portfolio-hedging activities.
Research Papers by Federal Reserve Staff 6
One of these papers estimated the pass-through by Fannie Mae and Freddie Mac of their fundingcost advantage into primary mortgage rates, finding a mere 7 basis points of pass-through. Another paper
provided evidence against the GSEs’ claims that their purchasing behavior stabilizes mortgage rates
during periods of market turbulence. Other papers discuss (i) likely competitive interactions between
the GSEs and large banks that will be subject to Basel II capital regulation and (ii) the ill-structured
incentives the GSEs face to increase the size of their portfolios.
Ad Hoc Federal Reserve Study Group Examining GSE Impacts on Interest Rate Derivatives Markets
(Board of Governors, 2005)
The study group identified potential channels through which disruptions at the GSEs could flow
through to other market participants in the over-the-counter markets for interest rate derivatives, like
swaps, interest rate options, and swaptions (options on swaps). The study group reported that market
participants felt current risk-management practices were sufficient to contain risks posed by the GSEs.
Economic-Capital Analysis of GSEs by Morgan Stanley (Posner, 2005)
Kenneth Posner, an equity analyst at Morgan Stanley, isolated the distinct economic risks faced by
the GSEs and estimated how much capital the firms would need to provide adequate protection to
debtholders to justify an AA senior-unsecured bond rating. This analysis assumed that there would be
no support forthcoming (or expected by financial-market participants) from the federal government.
His estimate of the required equity-to-assets capital ratio was in the range of 4 to 7 percent, about twice
as high as the current GSE ratios of closer to 3 percent. Thus, the GSEs would be significantly undercapitalized today if there were no expectation of government support of their liabilities.

These include Passmore (2005), Passmore, Sherlund, and Burgess (2005), Lehnert, Passmore, and Sherlund (2006), Hancock et al. (2005),
Frame and White (2005), and Emmons and Sierra (2004).

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Milton Friedman and U.S. Monetary History:
1961-2006
Edward Nelson
This paper, using extensive archival material from several countries, brings together scattered
information about Milton Friedman’s views and predictions regarding U.S. monetary policy
developments after 1960 (i.e., the period beyond that covered by his and Anna Schwartz’s Monetary
History of the United States). The author evaluates these interpretations and predictions in light
of subsequent events. (JEL E31, E51, E52, E58)
Federal Reserve Bank of St. Louis Review, May/June 2007, 89(3), pp. 153-82.

ilton Friedman and Anna J.
Schwartz’s (1963) A Monetary
History of the United States covered a 93-year period: 1867 to
1960. Milton Friedman lived until November
2006—46 years beyond the period covered by
the Monetary History and a length of time equal
to nearly half that covered in that book. Throughout 1961-2006, Friedman commented publicly
on U.S. monetary policy developments. This
paper attempts to provide a perspective on
Friedman’s account of 1961-2006 U.S. monetary
history by studying the observations he provided
over that period.
Friedman provided no single detailed assessment of post-1960 U.S. monetary developments.
Though Paul Samuelson once speculated of a
time when “Milton Friedman and Anna Schwartz
come to write their history of the crimes of 1974
and 1975” (NYT, 02/26/75),1 the Monetary
History was the single volume of monetary history
1

In this paper, newspaper and magazine articles are cited in the
text with their abbreviation and date. A key to the abbreviations
is given in Appendix A, and Appendix B gives the newspaper
articles referenced in chronological order.

produced by the two authors; Friedman and
Schwartz’s subsequent collaborations were not
a continuation of their historical analysis.2
Friedman (1984a) did provide a capsule history
of monetary developments from 1960 to 1983;
but not only did this study ultimately cover only
one half of the post-1960 period through which
Friedman lived, but Friedman’s own views of
1979-83 developments underwent major revision
in the years after 1984. There is thus no single
definitive record by Friedman available of his
version of events. But major elements of it can be
recovered, as there are many forums to which he
contributed over this period that contain his observations on contemporary monetary policy. I therefore study Friedman’s account of 1961-2006 using
a variety of sources: not only Friedman’s post2

In particular, Friedman and Schwartz’s (1982) Monetary Trends
has “1867-1975” in its title but is not an update of the monetary
history to 1975; rather, the authors offered a “statistical and theoretical analysis” to complement the “chronological and largely
qualitative analysis” of the Monetary History (Friedman and
Schwartz, 1982, p. xxviii). Consistent with this, Friedman and
Schwartz (1982) mention Arthur Burns several times, but it is
always with reference to Burns’s scholarly work on business fluctuations and never with reference to his position as Federal Reserve
Chairman from 1970 onward.

Edward Nelson is an assistant vice president and economist at the Federal Reserve Bank of St. Louis. The author thanks Richard Anderson,
Mario Crucini, Amit Kara, David Laidler, Anna Schwartz, and David Wheelock for comments on an earlier draft of this paper. Justin Hauke
provided research assistance, and Kathy Cosgrove, Marc Giannoni, Katrina Stierholz, Julia Williams, and Andreas Worms assisted with
recovering archival material.

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1960 writings on monetary affairs, but other public
statements he gave in media interviews, speeches,
and congressional testimony. This broad source
base includes—over and above Friedman’s contributions to books, journals, and media—reporting on Friedman’s public statements that appeared
in newspapers and magazines in the United States,
the United Kingdom, Australia, Canada, Germany,
Hong Kong, Ireland, Israel, New Zealand,
Singapore, and South Africa.3
My discussion moves between material drawn
from Friedman’s statements in the media and
material from his contributions to specialist
monetary economics outlets. This approach
might be questioned. Friedman’s critics have
sometimes argued that Friedman’s economic
analysis was not consistent across his technical
and popular writings. In particular, they alleged
that Friedman used a harder-line and more
mechanical version of monetarism in his journalism. This criticism, first made by Paul Samuelson
and James Tobin, has recently been revived by
Krugman (2007a).4 In my view, however, the
criticism is without merit. Friedman (1970a,
1972a) provided detailed examples showing that
the monetary analysis in his popular writings
was consistent with that in his technical work,
and this judgment has been affirmed by Gordon
(1976) and Nelson (2004). More recently, Schwartz
and Nelson (2007) provide a rebuttal to Krugman
(2007a) on this issue.

CRITIC OF MONETARY POLICY:
1961-68
The London Financial Times in late 1962
referred to “Americans’ surprising addiction to
pre-Keynesian economics” (FT, 12/29/62), a
remark undoubtedly inspired by the U.S. economic policy record of the 1950s. That period
3

Previous studies of Friedman’s contribution to policy debates
include Frazer (1988), Hammond (1996), Leeson (2000), and
Nelson (2004). Due to my expanded base of source material and
my focus on U.S. monetary history, the overlap here with those
studies is minor.

The earlier articulations of this argument appeared in Tobin (1970)
and a 1968 commentary by Samuelson (STE, 12/15/68).

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was characterized, in addition to fiscal conservatism, by a monetary policy directed at restraint
on aggregate demand, as Romer and Romer (2002)
show. Romer and Romer provide evidence, based
on documentary material and policy-rule estimates, that U.S. monetary policy had a modern
inflation-oriented outlook—one acknowledged,
albeit pejoratively, by Paul Samuelson in 1965
when he referred to the Federal Reserve’s “antiinflation paranoia of the 1950s” (FT, 12/31/65).
Romer and Romer (2002, p. 121) argue that
Milton Friedman did not judge 1950s monetary
policy favorably. This understates Friedman’s
praise of 1950s monetary policy, both in the
Monetary History with Schwartz and subsequently.
Though a critic of the Federal Reserve’s overall
record since its inception, Friedman praised the
mid- and late-1950s policy of “restraint…[which]
eliminated inflation by 1960.”5 Friedman and
Schwartz (1963, p. 628) had praised the “nearrevolutionary change” in official statements in
1952-54 toward acknowledging the importance
of the money supply, and in 1965 Friedman suggested that the Federal Reserve’s attention to
money supply data during 1959-60 helped stop
the recession of 1960-61 from being worse.6
Friedman argued that a large part of the credit
for the anti-inflationary monetary policy of the
1950s was due to the Eisenhower Administration,
for showing solidarity with the Federal Reserve
and resisting the “temper of the time” that favored
aggressive stimulation of aggregate demand (NW,
12/06/76). The burying of inflationary expectations by the early 1960s, Friedman contended,
resulted from “the [economic] slowdown that
Mr. Eisenhower was willing to accept at the end
of the 1950s” (CHA, 11/73).
While applauding the price stability that the
monetary policy of the late 1950s had produced,
Friedman felt that a steadier policy, involving
fewer fluctuations of money growth around its
downward trend, could have generated the same
result. Actual policy, he believed, had worsened
business cycle fluctuations by ill-timed finetuning. Thus the 1950s were not excluded from
5

Friedman (1984a, p. 26).

See Friedman (1968a, p. 146).

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Nelson

(i) his generalization in 1967 that “[t]hroughout
the post-war period…the Fed has tended first to
delay action and then, when it did act, to go too
far” (NW, 10/30/67) or (ii) his statement in 1964
that “we ought to convert monetary policy from
being a destabilizing force into at least being a
neutral factor.”7
Monetary policy, already expansionary from
mid-1960, became more so from 1961, with both
the Kennedy Administration and the Federal
Reserve supporting stimulation of the economy.
This monetary expansion is evident in an increase
in money growth (using today’s M1 and M2 definitions) during the first half of the 1960s. Most of
the shift to a higher growth rate was completed
in 1961, with money growth in the succeeding
years quite smooth. That smoothness, Friedman
suggested, was why the United States avoided a
recession after 1960.8 Friedman developed this
theme in an October 1965 consultant’s memorandum to the Board of Governors, which noted
that in the prior three years “monetary growth
has been relatively stable by past standards,” an
“excellent” monetary policy performance.9 Consistent with his 1965 judgment, Friedman came
to regard the early-to-mid 1960s as testament to
the value of stable monetary growth; in 1977, for
example, he calculated that the standard deviation
of M2 growth for 1963:Q3–1966:Q4 was close to
the lowest observed in the postwar era for any
period of comparable length.10
Friedman served as economic advisor to
Republican candidate Barry Goldwater during the
1964 presidential election campaign. Goldwater
eventually suffered a landslide defeat to President
Lyndon Johnson. Friedman’s monetary policy
proposals were not likely to be implemented
even if Goldwater had won, as Goldwater had
already said that a constant money growth rule
“would require too fundamental a change in our
7

Friedman (1964, p. 1156).

See Friedman (1984a, p. 27).

See Friedman (1968a, p. 147).

See Friedman and Modigliani (1977, p. 16). This calculation
roughly agrees with what emerges from examining present-day
data on the modern definition of M2. Using this series, the lowest
value of the 14-quarter standard deviation of money growth takes
place for the period 1962:Q4–1966:Q1. See Figure 1.

F E D E R A L R E S E R V E B A N K O F S T. LO U I S R E V I E W

monetary system. We must continue to work
within the framework of the independent Federal
Reserve System” (CSM, 09/28/64).11
Friedman’s 1965 memorandum applauded
the increased average money growth in 1962-65
as an improvement over the inadequate rates of
1958-60, but judged that M2 growth had now
overshot its desirable rate. He acknowledged that
the upward trend of money growth had so far led
to greater output growth with very little increase
in inflation, but attributed this to the impact on
expectations of the late 1950s period of austerity.
Inflationary expectations, he felt, were now
returning, and so the time was now overdue for a
“moderate reduction” in M2 growth.12 When,
therefore, the Fed tightened monetary policy in
late 1965, raising the discount rate on December
6, Friedman voiced his approval for the measure
(SLGD, 12/09/65).
At the same time, Friedman spoke out against
the Johnson Administration’s increasing emphasis on wage-price guidelines to restrain inflation.
“Price control by exhortation and threat and use
of extra-legal powers never has worked and never
will, except to disrupt the economy. The cure is
worse than the disease. Holding down a few
prices here and there only diverts inflationary
pressure elsewhere, just as squeezing the corner
of a balloon pushes the air into the rest of it”
(SLGD, 12/09/65).13 He was equally scornful of
more general controls: “Direct control of prices
and wages does not eliminate inflationary pressure. It simply shifts the pressure elsewhere and
suppresses some of its manifestations. The only
way to stop inflation is to restrain the rate of
growth of the quantity of money” (CT, 05/08/66).
By late 1966, Friedman was worried that the
Federal Reserve had moved too far in the direc11

In fact, Friedman and Goldwater, while sharing similar limitedgovernment aspirations, had little agreement on economic management issues. Friedman supported the Kennedy-Johnson tax cut,
while Goldwater voted against it in the Senate. Friedman viewed
inflation in 1970-71 as monetary in origin and opposed wage-price
controls; Goldwater blamed cost-push factors and supported price
controls.

Friedman (1968a, p. 152).

Here and below, where newspaper coverage of Friedman’s public
appearances are quoted in the text, the quotations correspond to
the direct quotations attributed to Friedman in the articles.

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tion of restraint and said the U.S. economy was
“headed straight for recession in the next two or
three months” (CSM, 12/19/66). Similarly, in
Newsweek in early 1967 Friedman wrote that it
was “almost surely too late to prevent a recession”
(NW, 01/09/67). Actual data now show a sharp
slowdown in real GDP growth in late 1966 and
the first half of 1967, but no decline in output.
There is also no recession in 1967 according to
the official National Bureau of Economic Research
(NBER) chronology. Nevertheless, Friedman and
Schwartz (1982, p. 74), in their own business cycle
dating, amended the NBER chronology to categorize 1966-67 as an economic contraction. Partial
justification for this choice is that their study was
concerned with relations between money stock
movements and nominal income movements, and
1966-67 is an important episode in this respect.
Nominal income slowed down much more than
output, in what Friedman later judged was an
unusual instance of inflation responding as rapidly
as total spending to a tightening of monetary
policy.14 In fact, four-quarter CPI inflation actually came back below 3 percent in the first half
of 1967 after crossing the 3 percent barrier in
1966. It then rose about 3.5 percentage points
over the rest of the 1960s.
In 1968, the joint House-Senate economic
committee made a nonbinding recommendation
that the Federal Reserve be judged by the criterion
of meeting a 2 to 6 percent growth rule for the
money supply. Friedman applauded the proposal,
suggesting that the most important change would
be “for the Fed to be aware of the attitude of
Congress” regarding the desirability of steady
money growth (CT, 07/05/68). The 1968 proposal
in itself came to nothing, but was a precursor to
the congressional resolution that established
monetary targets in 1975.

WAGE-PRICE CONTROLS AND
MONETARY TARGETS: 1969-75
In January 1969 Friedman called for Federal
Reserve Chairman William McChesney Martin Jr.

to step down. Though Martin was due to retire
in January 1970, Friedman told Time magazine,
“It would be a very good thing if he went early”
(TIME, 01/10/69). Despite the public acrimony,
Friedman and Martin continued to correspond
privately, and in early 1969 Friedman wrote to
Martin urging the Fed to adopt a money stock
target, with Friedman offering to help design
procedures to ensure better control of monetary
aggregates. Martin replied that it was “quite true”
that better control of monetary aggregates was
feasible, but expressed doubt that stabilization
of monetary growth was actually desirable.15
Friedman welcomed the appointment of
Arthur Burns as Federal Reserve Chairman in
January 1970, declaring Burns as “the first person
ever named Chairman of the Board who has the
right qualifications for that post,” and expressing
the hope that Burns would deliver money growth
“high enough to encourage recovery…but low
enough to avoid renewed inflation” (NW,
02/02/70). Friedman rapidly became disillusioned
when Burns began a series of speeches calling for
an incomes policy to help in fighting inflation.
And over the course of 1970, Burns adopted a
progressively stricter cost-push analysis of inflation. To Friedman, such an analysis, along with
the corresponding policy recommendation of
direct government intervention in price and wage
formation, was outdated and discredited by empirical evidence. Friedman himself had embraced
cost-push views in his pre-monetarist days (see
Despres et al., 1950), but it had been superseded
in the previous 20 years by his monetarist view of
inflation, according to which inflation depended
on monetary forces through excessive aggregate
spending. As he put it in July 1970, “To each
businessman separately it looks as if he has to
raise prices because costs have gone up. But then,
we must ask, ‘Why did his costs go up? Why is
it that [for example] from 1960 to 1964 he didn’t
find that he had to pay so much more for labor
he had to raise prices, but that suddenly from
1964 to 1969 he did?’ The answer is, because, in
the second period, total demand all over was
increasing” (CDN, 07/29/70).
15

See Friedman (1972b, p. 14).

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William McChesney Martin Jr. letter to Friedman of April 7, 1969,
quoted in Friedman (1982a, p. 106).

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The disagreement led Friedman in May 1970
to send Burns a lengthy handwritten letter critical
of Burns’s statements on incomes policy. The
Philadelphia Inquirer reported that Burns was
shaken by the letter and suggested that relations
between Burns and Friedman had deteriorated
(PHI, 05/29/70). A permanent rift between the
two occurred. Nevertheless, claims that Friedman
and Burns broke off communications completely
in 1970 (or 1971) are false. The two met and spoke
at the Federal Reserve Board during Friedman’s
appearances (until 1974) as an academic consultant; and they continued to correspond over 197071.16 In 1985 Friedman even described Burns as
“still among my closest friends,”17 but this was
certainly an exaggeration.
In an interview with the Chicago Daily News,
Friedman specifically disputed the notion that
strong labor unions had, as claimed by Burns,
become important as a source of inflation.
Friedman noted: “You can look around the world
and find countries that have had very strong trade
unions and no inflation…The fact is that there is
little relation between trade unions and inflation”
(CDN, 07/29/70). Wage growth, he stressed on a
later occasion, was only a symptom of inflation:
“It isn’t the wet street that caused the rain” (OKL,
05/19/81).
Nevertheless, belief in union monopoly power
as a cause of inflation remained prevalent.
President Nixon, with Burns’s support, introduced wage-price controls on August 15, 1971,
beginning with a three-month freeze. Friedman’s
reaction was that the measures were “purely cosmetic in nature, not therapeutic” (NYP, 08/16/71).
Friedman also criticized the controls in a meeting
with Nixon in September 1971.18
Friedman did react favorably to another of
the measures Nixon announced in August 1971:
the end of the U.S. commitment to a pegged gold
price. A longtime advocate of floating exchange
16

See Friedman (1982a, pp. 106-10).

Friedman (1986, p. 81).

See Friedman and Friedman (1998, p. 387). On a visit to the
National Archives in May 2002, Friedman listened to the recording
of his September 1971 meeting with Nixon, but found that substantial portions of the recording were unintelligible.

F E D E R A L R E S E R V E B A N K O F S T. LO U I S R E V I E W

rates, Friedman welcomed the end of this mainstay of the postwar fixed exchange rate system.
He proclaimed in September 1971, “The Bretton
Woods system is dead” (JT, 09/24/71). This judgment was borne out by the failure, over the following 18 months, of attempts to restore international
cooperation on fixed-rate arrangements.
At the end of 1971, Friedman renewed his
attack both on Burns’s diagnosis of cost-push
inflation and Nixon’s attempted cure of controls.
“We have been driven into a widespread system
of arbitrary and tyrannical control over our economic life, not because ‘economic laws are not
working the way they used to,’” Friedman began,
alluding to a phrase Burns had used, “not because
the classical medicine cannot, if properly applied,
halt inflation, but because the public at large has
been led to expect standards of performance that
as economists we do not know how to achieve.”19
Friedman said that Burns’s embrace of cost-push
views reflected “the propensity of economists to
appeal to a change in our economic structure
whenever they are puzzled” and that Burns had
revived old fallacies about inflation.20
In 1973 Friedman went on to declare that
controls were the “worst mistake in American
economic policy that has been made by an
American president in the last 40 years” (OAK,
06/15/73) and added that U.S. business leaders
had shown “ignorance and shortsightedness” in
endorsing the control measures (JT, 10/15/73).
Friedman’s consistent opposition to guidelines
and controls contrasted with the position of leading Keynesian economists during the 1960s and
1970s. For example, Arthur Okun, who had
helped shape the Kennedy and Johnson administrations’ wage/price guideposts, applauded
President Nixon’s adoption of wage/price controls.
In December 1972 Okun said that some form of
wage-price controls would be in effect “for the
rest of our lives,” adding, “I’ll bet a nickel that
we never hear another U.S. President say what
President Nixon said in 1969 and 1970, that the
government has no role over private wage and
price decisions” (KCS, 12/07/72). This example
19

Friedman (1972b, p. 17).

Friedman (1972b, p. 11).

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and many similar ones show that Krugman
(2007b) is incorrect to suggest that Friedman’s
opposition to the Nixon wage/price controls was
widely shared by nonmonetarists.
Though opposed to the changes in inflation
analysis that were taking place over 1970-71,
Friedman did modify his own position on inflation in one major respect during this period. Before
1971, he had believed that output and inflation
reacted simultaneously to prior monetary policy
actions.21 This led him to predict in August 1969
that inflation would begin declining by the fourth
quarter of 1969 (DOM, 08/24/69) and to admit in
June 1970 that the impact of the 1969 monetary
policy tightening on inflation was “coming
later than many of us hoped or expected” (CT,
06/29/70). In late 1971 Friedman reexamined
postwar evidence and found an 11- to 31-month
lag from monetary growth to inflation,22 leading
to his later summary of the evidence that there was
a two-year lag from money growth to inflation and
“output responds more quickly than prices...”23
The two-year rule of thumb from monetary policy
actions to inflation, which entered Friedman’s
framework in 1971, has since become standard.24
If Friedman’s confidence about timing relations between money growth and the components
of nominal income growth increased in the 1970s,
he remained as skeptical as ever about estimating
structural aggregate supply relationships. His
proposition that the appropriate Phillips curve
specification was an expectational version
(Friedman, 1968b) was gaining acceptance in
academia, but Friedman continued to doubt that
a durable specification could be implemented
21

Friedman had always believed that U.S. prices had considerable
stickiness; for example, in 1969 he had written, “Inflation has an
inertia of its own. Many prices and wages are determined long in
advance…” (NW, 08/18/69). But he believed that sizable (though
incomplete) responses of inflation to monetary policy actions
appeared at the same time as output responses and, in late 1970,
had modified this only to the view that prices reacted 6 to 9
months behind output (Friedman, 1970b, p. 15).

See Friedman (1972b, pp. 14-15).

Friedman (1975, p. 178).

For example, Bernanke, Laubach, Mishkin, and Posen (1999, pp.
319-20) state that “research regarding how long it takes monetary
policy to influence inflation…indicates that the lag is on the
order of two years (a common estimate).”

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empirically. This was especially so with those
Phillips curves that used unemployment-based
measures of economic slack; Friedman thought
that Okun’s law relationships were unstable. His
doubt, expressed in 1968, that the natural rate of
unemployment could be measured reliably was
reinforced by evidence that in the 1970s the relationship between the rates of employment and
unemployment had loosened (NW, 02/07/77).
Asked in 1974 how much unemployment was
needed to cure inflation, Friedman gave the nonanswer, “To answer that question is like answering
the question, ‘When did you stop beating your
wife?’” (IT, 09/18/74). Nevertheless, he confirmed
that “There is no way of slowing down inflation
that will not involve a transitory increase in unemployment, and a transitory reduction in the rate
of growth of output. But these costs are far less
than the costs that will be incurred by permitting
the disease of inflation to rage unchecked” (TG,
09/16/74).
In explaining why monetary conditions had
been allowed to become so relaxed in 1972,
Friedman judged that “the Fed became worried
about rising interest rates” (LAT, 02/18/73), adding
more generally in 1978 that pressures “to keep
interest rates low are a major reason for high monetary growth” (NW, 04/24/78). Friedman emphasized that the failure to allow nominal interest
rates to exceed inflation was inhibiting price stability and that only a period of disinflation could
permanently deliver low nominal interest rates.
Hence his recommendation: “The best way to
hold rates down in the long run is for the Fed to
raise them temporarily” (LAT, 02/18/73).
In addition to criticizing official efforts to
hold down nominal interest rates in securities
markets, Friedman condemned the U.S. government for providing inadequate returns to holders
of nonmarketable debt. Savings bonds, he declared
in early 1976, were the “greatest ripoff in modern
history” and “anyone who has bought savings
bonds in the past ten years has been taken to the
cleaners” (OAK, 02/12/76). He was no less acerbic
when he returned to the theme in 1987: “Savings
bonds were the biggest steal of all. The government
was able to get suckers to buy savings bonds
yielding much less than the inflation rate” (SFC,
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Nelson

08/18/87). In 1974, Friedman had called for
government-indexed savings bonds to provide a
vehicle for small savers to protect the purchasing
power of their assets (DC, 08/16/74).
With Friedman’s criticisms of U.S. monetary
policy gaining ground, Chairman Arthur Burns
wrote a letter to Senator William Proxmire in
November 1973 (subsequently published in
Federal Reserve outlets: Burns, 1973) that apparently denied Federal Reserve responsibility for
inflation and, in part, for money growth as well.
This prompted Friedman himself to write a
bristling rebuttal, also in the form of a letter to
Proxmire, in early 1974 (Friedman, 1974).
Friedman was particularly scornful of Burns’s
statement, “The severe rate of inflation that we
have experienced in 1973 cannot responsibly be
attributed to monetary management.” “As written,”
Friedman began (1974, p. 20), “this sentence is
unexceptionable. Delete the word ‘severe,’ and
the sentence is indefensible.” Commodity price
increases and other one-time events, Friedman
said, might explain why U.S. inflation in 1973
reached 8 percent instead of 6 percent, but not
why inflation could reach 6 percent in the first
place; moreover, the more years one considered,
the less valid it was to invoke nonmonetary events
to explain inflation. Thus “the Fed’s long-run
policies have played a major role in producing
our present inflation.”25
The Federal Reserve did tighten monetary
policy over 1973, and in October 1973 Friedman
predicted a recession of which already “we might
be in the early stages” (PHB, 10/12/73). The
National Bureau of Economic Research later
dated the 1973-75 recession as having begun in
November 1973.
October 1973 also saw the OPEC oil embargo
and the announcement of permanent oil price
increases. Friedman would have a checkered
record in predicting the course of oil prices. In
September 1973 he had said that food and commodity prices had undergone a “tremendous
bubble…[which] cannot last” (NW, 09/17/73),
thereby implying that their likely direction was
down, not up. When OPEC then announced its
25

Friedman (1974, p. 21).

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large price increases, Friedman predicted that in
four to five years “oil will be coming out of our
ears” because “cartels inevitably break up sooner
or later” (PHB, 11/09/73). He later cited the Iran
revolution and counterproductive energy policies
in the United States as the source of resilience in
the oil price for the rest of the 1970s. Weaker oil
prices in the early 1980s eventually provided
some support for Friedman’s initial skepticism
about OPEC, and he accurately predicted further
weakness to come. “Betting on continued high oil
prices is equivalent to betting on a disruption in
the Middle East,” he said in Norway in September
1982. “I am not talking about a reduction from
$32 to $30 a barrel, but a drop to somewhere
around $15 to $20” (SCMP, 09/17/82). His further
conjecture that, longer-term, the real oil price
would return to its pre-1973-shock value was
borne out during some of the 1990s.
Friedman consistently stressed, however,
that success in controlling inflation was not contingent on oil prices beyond the very short run.
“If you spend more on oil, doesn’t that leave you
less to spend on something else? Why don’t other
prices come down, or not rise as rapidly? It’s a
complete fallacy to suppose that the rise in the
price of oil, or of other commodities, has had any
significant effect on inflation” (TG, 09/16/74).
Wage and price controls came to an end in
1974, but Friedman remained irritated by the
proliferation of false cures for inflation. After
attending a two-day summit on inflation hosted
by President Ford, Friedman deplored the “bewildering variety of proposals for governmental
action” (NW, 10/14/74). “You can’t stop inflation
without unemployment and stagnation,” he added
in 1975. “All this business about consumers saving more and reusing paper plates to control inflation—that’s nonsense” (PHB, 03/02/75). Friedman
also criticized Chairman Burns for still failing to
acknowledge sufficiently the Fed’s role, in the
early 1970s, in producing the inflation surge of
1973-74 (WSJ, 08/21/75). On a more positive note,
Friedman was pleased that floating exchange
rates had become the norm and judged that they
had been “effective shock absorbers” against
recent years’ events, such as the OPEC shock
(WSJ, 06/30/75).
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Another development that Friedman initially
saw as very positive was the Federal Reserve’s
adoption, after a congressional resolution, of
monetary targets in 1975. But within a few years
he would conclude that the targets had been
implemented in a way that had not led to the
desired changes in monetary policy. Among
Friedman’s criticisms of the implementation
were that the Federal Reserve avoided accountability by introducing target bands for both M1 and
M2 growth instead of a point target for a single
aggregate (Friedman, 1984a, p. 27). The Federal
Reserve also continued to use a federal funds rate
instead of the monetary base instrument, which
Friedman preferred. While Friedman acknowledged that monetary targeting with a funds instrument was feasible, he contended that inertia in
adjusting the interest rate meant that monetary
target misses would be serially correlated when
a funds instrument was used (NW, 12/08/75).

Election day 1976 coincided with Friedman’s
announcement of a change of location. He would
leave Chicago at the end of November and move
to San Francisco to become a research fellow at
the Hoover Institution, Stanford University, following a six-month spell in late 1976 and early
1977 as a visiting scholar at the Federal Reserve
Bank of San Francisco (CT, 11/02/76; NYT,
11/03/76).
Shortly after the election, Friedman said he
hoped that once in office President Carter would
“rise above his advisors” and not try to stimulate
aggregate demand aggressively (PHB, 11/15/76).
He also provided a scenario, in a December 1976
Newsweek column, regarding the likely result of
following expansionary policies in 1977, which
proved to be prophetic:
If Mr. Carter tries to put his advisors’ policies
into effect and succeeds in doing so—including
getting the Federal Reserve System to speed
up substantially the rate of monetary growth—
there might be a sudden spurt in the economy
and a quick reduction in unemployment. However, these good results would be temporary.
By 1978 or 1979, inflation would be back in
double digits and wage and price controls
would be in place or in contemplation. By 1980
at the latest, unemployment would be rising
sharply. As Machiavelli might say: what a way
to face the 1980 election! (NW, 12/06/76)

NEW PRESIDENTS, NEW
CHAIRMEN, NEW OPERATING
PROCEDURES: 1976-80
With money growth having come down from
its peaks in 1972, Friedman in early 1976 predicted accurately that U.S. inflation would fall to
4 to 5 percent by the end of 1976 (JOH, 04/05/76).
When this decline came about, however, Friedman
voiced unhappiness that achieving 5 percent inflation was now thought of “as doing a good job”
(PHB, 11/18/76).
Friedman warned in April 1976 that, while
money growth had recently picked up, slow
money growth observed in 1975 could interrupt
the U.S. economic recovery (JOH, 04/05/76).
Indeed, Friedman’s later verdict on 1976 was that
“the [monetary] slowdown in late 1975 produced
the economic pause in the second half of 1976
that played such a prominent role in the FordCarter election battle” (NW, 10/03/77). Ford’s
former press secretary later said that a rise in
unemployment before the election, associated
with the economic pause, was a decisive factor
in President Ford’s defeat (USAT, 12/27/06).26
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It was probably this commentary that
President-elect Carter had in mind when in
December 1976 he asked to be put through to
Milton Friedman and began, “I’ve wanted to talk
to you, but first let me congratulate you on the
[Nobel] prize.” Unfortunately, Carter’s staff had
connected him not to Milton Friedman but to
Mr. Milton (Milt) Friedman, a member of President
Ford’s staff (DFP, 12/25/76).27 Carter’s staff finally
connected him to the Milton Friedman, who later
described his conversation with Carter as a “pleasant talk” but provided no details (Friedman and
Friedman, 1998, p. 459).
26

The unemployment rate in the third quarter of 1976 was slightly
higher than in the previous quarter.

Ford’s staff member Milton Friedman had served as senior speechwriter and special assistant to the President (TDN, 02/05/76).

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The pleasantries did not endure into 1977
and, shortly after Carter took office, Friedman
spoke dismissively of the new administration’s
proposed tax rebate. Reaffirming his skepticism
about the effectiveness of fiscal policy, Friedman
asked an interviewer, “How can the government
stimulate the economy by taking money out of one
pocket of the public and putting it into another
pocket?” (USNR, 03/07/77). Carter withdrew the
tax rebate proposal in April 1977.
In an interview with a St. Louis reporter in late
1977, Friedman returned to the themes covered
in his Nobel lecture of a year earlier.28 “[I]nflation
is a lot like alcoholism,” he said. “When you drink,
the good effects come first, and the hangover
comes the next morning. When an inflationary
period starts, spending goes up and employment
rises along with it.” By an “inflationary period,”
Friedman explained he meant the initiation of
an easy monetary policy, which usually preceded
the actual upturn in inflation. “By printing money
at a faster rate you may be able temporarily to
create an appearance of prosperity, but only so
long as you fool the people. Once the public comes
to realize what is going on, higher inflation means
higher unemployment! Just look at the example
of the U.S., Great Britain, and every other country”
(SLGD, 12/16/77).
Friedman was asked whether he thought
Chairman Burns would receive another term
from President Carter. Friedman said it would
not make much difference: Despite an inflationfighting reputation, Burns in practice had produced “a Fed which is promoting inflation.”
Monetary targets had not made a difference to
this, said Friedman, because “while the targets
are going down, actual monetary growth is going
up” (SLGD, 12/07/77). His own opinion was that
the “chances are good” that Burns would be reappointed (SLGD, 12/16/77). In late December 1977,
Carter actually announced a new Chairman, G.
William Miller, who took office in March 1978
and about whom Friedman ultimately wrote very
little.
In April 1978, double-digit M2 growth in
1977 led Friedman to predict that “inflation from
28

The 1976 Nobel lecture was published as Friedman (1977).

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February 1977 to October 1979 will average something like 7 to 10 per cent…[and] no sustained
reduction in inflation can be expected before midor late 1979” (NW, 04/24/78). The following
month Friedman made more specific predictions:
Inflation “probably will be eight or nine per cent
by the end of the year, and may be in double
digits in 1979” (MHER, 05/22/78). These predictions were realized.
The appointment of Paul Volcker as Federal
Reserve Chairman in 1979 gave Friedman an
opportunity to reflect on the record of money
growth and inflation in the past two decades. He
noted that inflation exhibited a steeper upward
trend since 1960 than did M2 growth. This was
“no mystery…It reflects the widening recognition
that inflation is the way of the future. Those inflationary expectations make it prudent for all of us
to reduce the fraction of our assets in the form of
money.” This pattern, in reverse, would become
important in interpreting 1980s monetary developments. Friedman continued, “The problem is
not, as President Carter asserts, a lack of confidence. The problem is rather that the public is
very confident that the government will produce
inflation and will mismanage the economy. We
do not need more confidence in bad policies. We
need better policies” (NW, 08/20/79).
In October 1979, the Federal Reserve inaugurated its new operating procedures, intended to
deliver greater control of monetary growth and
permit larger transitory fluctuations in the federal
funds rate. Speaking to a local reporter shortly
after the procedures were announced, Friedman
called them a “long overdue change,” but added,
“I remain skeptical until I see proof” that a material change in policy had taken place. The need
for a change in regime was urgent, Friedman said,
because “sooner or later, the adverse effect of inflation will destroy the country” (SFC, 10/18/79).
In July 1980, Friedman pronounced a negative
verdict, declaring that the erratic money growth
of the preceding months was a “disgraceful performance” that “confirms the doubts rather than
the hopes” about the new regime (NW, 07/14/80).
In May 1981 he further declared, “After studying
the Fed for [its] 67 years, I have no doubt that the
United States would be better off if the Federal
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Reserve had never been established” (NYDN,
05/22/81). In these and other critiques, Friedman
cited the Fed’s failure to reform its arrangements
with commercial banks as a major reason for the
instability in money growth. In particular, throughout 1979-82 (and into 1984), the required amount
of reserves that commercial banks had to keep
with the Federal Reserve continued to be determined on the basis of prior deposit levels. This
made aggregate reserves predetermined in the
short run and so inhibited short-run control of
the money stock.
Besides the new operating procedures,
Friedman was highly critical of direct controls
on credit introduced by President Carter and the
Federal Reserve in March 1980. Friedman (1982a,
p. 103) said the rationale for the controls was the
fallacious real-bills doctrine, according to which
certain types of spending are particularly inflationary, so that control of inflation requires discouraging these spending categories. This contrasted with
Friedman’s own view that inflation responded to
total spending. Friedman also argued that the
controls would have adverse effects on saving
and investment (NW, 04/14/80). While ostensibly
the controls applied to credit rather than money,
the controls had a noticeable downward effect
on money growth, and output collapsed in the
quarter following the controls’ imposition. The
credit controls were withdrawn in July 1980.
On November 4, 1980, Ronald Reagan, about
whom Friedman had written supportively both
during 1980 and in Reagan’s 1976 campaign for
the Republican presidential nomination, was
elected president. Three days after the election,
the Soviet Union’s state-controlled press commented on the result, in the form of an article in
Pravda. The commentary noted, “In Ronald
Reagan’s entourage are found such experienced
public figures as former Treasury Secretary
William Simon, economists Alan Greenspan and
Milton Friedman, and other well-known people.”29 Ulam (1983) suggests that this respectful
reference to Friedman exemplified the Soviet
authorities’ regard for opponents who exhibited
ideological consistency. If this assessment is accu29

Quoted in Ulam (1983, p. 288).

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rate, the respect for consistency presumably offset the Soviets’ opposition to much of Friedman’s
record, including his advocacy of free markets
and his recent meeting with Chinese government
officials. On the other hand, Friedman’s views
on monetary policy were probably not among
his most objectionable opinions for Soviet officials; after all, as Friedman wryly observed on
several occasions, Karl Marx was a monetarist.30

THE YEARS OF CONFUSION:
1981-85
The years 1981 to 1985 saw several major
blemishes appear on Friedman’s forecasting
record, and many changes in the details of his
analysis of recent U.S. monetary policy developments. The outcome was a confused record of
public statements on Friedman’s part. By far, the
period 1981-85 marks Friedman’s most inconsistent period since he became a monetarist in
1950-51.31 It was 1986 before Friedman settled
on positions in describing 1980s developments
that he maintained for the remaining 20 years of
his life.
In September 1981, Friedman commented in
Newsweek that “Institutional change, notably the
explosion in money-market mutual funds, has
rendered narrow monetary aggregates misleading.”
He accordingly used M2 to judge monetary policy
settings (NW, 09/21/81). If Friedman had stuck
with this judgment throughout the following years,
he would probably have been able to avoid some
of his worst—and most-publicized—macroeconomic forecasts. Certainly in 1981-82 Friedman’s
record on inflation forecasting continued to be
good; in October 1981 President Reagan told the
press that inflation was “in single digits now, and
I was interested to see that our Nobel economics
prize winner, Milton Friedman, has just been
quoted as saying that he believes it’ll be down
30

See for example Friedman’s article “Marx and Money” (NW,
10/27/80).

David Laidler, an admirer and former student of Friedman, nevertheless certainly had Friedman in mind when he referred (Laidler,
1990, p. 59) to “careless monetarist predictions” that were made
in the early stages of the economic recovery that began in 1982.

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to six percent next year” (WCPD, 10/16/81). This
forecast, presumably based on the lower M2
growth after 1977, was borne out in U.S. inflation
outcomes in 1982.32
But in early 1982, Friedman abruptly switched
to using M1 on a near-exclusive basis (e.g., NW,
02/15/82). In October 1982, the Federal Reserve,
which had already shown signs since late summer of switching to a federal funds rate target,
announced that it was “de-emphasizing” its M1
target on account of continuing financial innovations. Friedman’s reaction to the double-digit M1
growth that followed in 1982-83 was to predict a
revival of inflation.
Indeed, from 1982 to 1985, Friedman repeatedly predicted a major revival of inflation that
never occurred. In 1982 he predicted 8 percent
inflation for 1983; the outcome was around 4
percent (FORT, 03/19/84). In July 1983, Friedman
wrote, “We shall be fortunate indeed if we escape
either a return to double-digit inflation or renewed
recession in 1984” (NW, 07/25/83). In August
1983, he said, “U.S. inflation rates will rise appreciably in 1984, although it’s not yet determined
where they’ll go from there” (TSN, 08/30/83). In
April 1984, Friedman said, “I believe [the CPI] will
be rising in the neighborhood of 8 to 10 percent
in 1985.”33 Even in November 1985, Friedman
said that “Inflation is not dead. It will emerge
once again and will be higher next year than it is
this year. We almost surely are currently at the
bottom of this inflationary episode and are likely
to be starting up again” (NYDN, 11/13/85). Defying
these predictions, inflation was consistently below
5 percent in every month from 1983 to 1986; moreover, apart from a brief uptick in early 1984, inflation continued to decline after 1982, and was
lower in 1986 than it was in 1985.
Questions that arise are why Friedman
increased his reliance on M1 in 1982 even as the
Fed was deemphasizing it; and why he in 1982-85
attached little weight to the position that financial
innovations were distorting M1, even though he
had taken this position himself in 1981.
32

In February 1982, Friedman went on to forecast 5 to 6 percent CPI
inflation by the end of the year (STR, 02/19/82).
Friedman in Heller et al. (1984, p. 46); see also NYT, 04/30/84.

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To answer these questions, it is worth going
back to Friedman’s past preferences in defining
money. As Friedman recalled in 1984, “In the past,
I always found M2 to be a more reliable guide to
economic events than the earlier M1.”34 His and
Schwartz’s Monetary History had used M2 as their
money series, and they had defended this choice
at length in their 1970 Monetary Statistics.35
This position hardened in 1978 when Friedman
saw the prospect of sweeps programs making M1
“a nearly useless aggregate” (NW, 10/30/78),
though in practice sweeps did not become a pervasive distortion until the 1980s and 1990s.
In 1980, the Federal Reserve made M1 and
M2 much broader definitions than they had previously been. The new definitions of money
were based on the type of deposit, irrespective of
whether the deposit was a liability of commercial
banks or of nonbank financial institutions. (So,
for example, demand deposits of nonbanks, previously included in neither M1 nor M2, were now
included in both M1 and M2.36) Friedman was
initially inclined to rely on the new M2 and, as
we have seen, argued in 1981 that M2 was more
immune to distortions from financial innovation.
But again, why did he come to rely on M1?
One major reason was the close relationship that
M1 growth and nominal income growth enjoyed
in the early 1980s—a “hot streak” of M1, discussed
here later. In addition, M1 gave a more unambiguous picture of tight money over 1981 and into
1982 than did M2, and so gave an accurate signal
both of the severe 1981-82 recession and the
1982-83 decline in inflation.
Friedman’s discounting of the Fed’s rationale
for its deemphasis on M1 arose partly from experience; it was not the first time the claim had been
made that financial innovations were disturbing
velocity behavior. In January 1977, Friedman
had said, “I have observed over a long period of
time that whenever anything goes wrong with
monetary policy, the favorite excuse of the monetary authorities is that there has been an exogenous
34

From his remarks in Heller et al. (1984, p. 51).

See Friedman and Schwartz (1963, 1970).

See Anderson and Kavajecz (1994).

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shift in the demand for money.”37 Similarly,
Friedman wrote in August 1982 that “the talk
about changes in the demand for money is simply
a red herring introduced by the Federal Reserve…
In each case it has turned out that there has
been no change in the demand for money...”38
Friedman was also chastened by his own lapse
in 1972, when he had briefly persuaded himself
that the high money growth of 1971-72 had been
permanently absorbed by a velocity shift and so
did not signal future inflation (NW, 10/16/72).
An article Friedman presented at the December
1983 American Economic Association meetings,
and which was published in 1984, represented
the high point of his confidence in M1 and so
combined a number of judgments that he would
retract within a few years. He stated (Friedman,
1984b, p. 398) that “Few if any monetarists ever
recommended the use of such broad aggregates
as the current M2 or M3 as monetary targets—
certainly, this one did not.” (This was not accurate—he had advocated M2 targeting in Friedman
[1982a, p. 117] and would again from 1986 on.)
He also stated that “The current M1 is conceptually…closer to the aggregate we [Friedman and
Schwartz] labeled M2 rather than to our M1…”
(This claim was also inaccurate: Federal Reserve
data showed that old M2 and new M2 were more
correlated than old M2 and new M1 before 1979.39
37

Milton Friedman, January 26, 1977, quoted in Friedman and
Modigliani (1977, p. 26).

Friedman (1982b). Other critics of the Federal Reserve took the
same perspective but expressed it with more intemperate language.
For example, Maxwell Newton, a monetarist financial columnist,
wrote in October 1982: “The justification offered to an evidently
credulous world for the Fed’s decision to allow the money stock
M1 to float way above target in the coming weeks is the hoary old
lie brought out by the Fed from time to time—namely that ‘financial innovations’ have made M1 less relevant or less accurate as a
measure of ‘money.’ This lie has been proffered by the Fed for at
least 40 years” (NYP, 10/12/82). By 1987, Newton had accepted
that M1 actually was distorted by financial innovations and had
switched to focusing on M2 in his analysis (TT, 07/20/87).

Correlations computed from the data for 1973:Q1–1979:Q4 tabulated in the Federal Reserve Bulletin (Simpson, 1980, p. 112) indicate that old M2 quarterly growth had a correlation coefficient of
0.54 with the new M1 growth series and 0.67 with the new M2
growth series. At various points, Friedman (e.g., 1984b, p. 398)
claimed that the new M1 was similar to the old M2 because the
new M1 series included interest-bearing deposits. But this claim
did not really hold up. The velocity of M1 remained much more
sensitive to variations in market interest rates than did M2, reflecting the fact that interest-bearing, variable-rate accounts were much
more important for M2 than for M1.

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Also, the new M1 shared with the old M1 the
“stylized fact” of an upward velocity trend in
the 1960s and 1970s, while the new M2 shared
with the old M2 a basically trendless velocity
over those decades.)
In retrospect, Friedman underestimated the
impact of financial innovations on M1, as well
as the extent to which high M1 growth reflected
a recovery of real balances after a disinflation. He
did acknowledge the latter as a factor in reducing
the level of velocity in 1982-83 (WSJ, 09/01/83),
but underestimated the extent of the increase in
money demand. Part of his error here reflected his
viewing M1, which is highly interest-elastic, as
similar to old M2, whose demand function was
less interest-inelastic. Consequently, he underestimated the impact that the shift to lower nominal interest rates from 1982 had in reviving the
demand for real balances. In addition, while aware
that much of the 3 percent per year pre-1981 trend
growth rate of M1 velocity was due to the inflationary monetary regime, Friedman initially conjectured that even under price stability velocity
would grow at about 1.5 percent per year because
“technological improvements in cash management” were not yet exhausted.40 It soon became
clear that disinflation since 1981 had instead
eliminated the M1 velocity trend altogether.
In May 1986, Friedman undertook a fundamental review of the monetary data in light of
developments in recent years, including his own
poor forecasting record on inflation, and settled
on M2 (with a one-time adjustment for the introduction of money market deposit accounts in the
four months to March 1983) as the appropriate
money series for U.S. monetary analysis.41 This
became the position he stuck to. If, as Friedman
thus concluded, monetary policy developments
in the early 1980s should have been analyzed
using M2 rather than M1, how does the picture
of this period change? The basic assessment that
monetary policy variability increased in the early
1980s is supported by using series other than M1.
Friedman’s (1984a, p. 29) tabulation of money
growth showed that the ups and downs of M1
40

Friedman (1984a, p. 58).

See Friedman (1988, pp. 229, 239-40).

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and M2 growth over 1979-83 were basically similar, while Erceg and Levin (2003) estimate that the
monetary policy swings in the early 1980s produced considerable variability in private sector
estimates of the long-run inflation rate. Also consistent with these authors’ findings is Friedman’s
statement that a principal channel through which
money growth variability was manifesting itself
in economic variability was interest-rate variability: As he put it, “What accounts for this unprecedentedly erratic behavior of the U.S. economy?
The answer that leaps to mind is the correspondingly erratic behavior of interest rates” (NW,
02/15/82). Friedman also judged that the high
variability had itself contributed to the downward pressure on aggregate demand, making the
recession worse and producing a larger decline
in inflation than would be expected from the
decline in money growth alone (ESN, 10/21/82;
Friedman, 1984b).
There are, however, some differences in an
account of 1979-82 that uses M2 rather than M1.
M1 growth unambiguously fell in the period from
late 1979 to mid-1982. M2 on the other hand, as
Friedman noted in 1981, was “flat” over 1978-81
in its annual average growth rates (NW, 09/21/81),
at about 8.5 percent, and continued at around
this rate in 1982. Seen from the perspective of
M2 growth, the 1979-82 period amounted to a
monetary policy sufficiently tight to hold the line
on the reduction in M2 growth achieved in 197778, frustrating the strong upward pressure on the
nominal quantity of money demanded that was
coming from high rates of nominal spending
growth.
In addition, while M2 velocity was roughly
trendless since the mid-1950s, it nevertheless
exhibited sustained movements over shorter
periods, rising in the 1970s and falling about 7
percent over 1981 and 1982. In line with his
1979 discussion of why inflation had risen more
steeply than M2 growth, Friedman attributed the
high money growth relative to inflation to agents’
flight back into money once they were confident
inflation had peaked (WSJ, 02/12/87). Studies
by Friedman and others found that M2 velocity
behavior in the postwar period could be accounted
for by opportunity-cost variables, leading
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Friedman to conclude that velocity in the 1980s
was explicable “despite all the talk about how
the relation between money and other variables
has shifted drastically in recent years.”42 M2
velocity settled down after 1983, by which time
most of the larger opportunity-cost movements
had taken place.43 Therefore, Friedman was able
to observe in June 1988 that from 1983:Q1 to
1988:Q1, nominal GNP had grown 7.4 percent per
year and M2 7.5 percent: “How much closer can
you get for a five-year period?” (WSJ, 06/22/88).
Friedman’s reliance on M1 in the mid-1980s
led him not only to successive errors in forecasting inflation, but also a well-publicized erroneous
short-term forecast for 1984. The sharp decline
in M1 growth during the second half of 1983 led
him to predict a recession starting in 1984:Q1.
“Mr. Reagan may well face a very difficult situation by next fall,” Friedman said in late 1983.
“There is a real threat of a recession in the first
half of 1984” (NYT, 12/31/83). Instead, real growth
continued throughout 1984 and was exceptionally strong in 1984:Q1. “I have no easy explanation of what went wrong,” Friedman said after
the strong output numbers were released (NYT,
04/30/84).
Friedman was, however, not as misguided in
his recession forecast as he had been in his
inflation predictions. While he was proven wrong
in his forecast of a recession in 1984:Q1, Friedman
was on the right track when he continued to
maintain that “there is not enough monetary fuel
going into the economic engine” and that this
had to show up before long in slower real and
nominal income growth (NYT, 04/30/84). The
Fed had, indeed, withdrawn a lot of monetary
stimulus in the second half of 1983 and continued
to do so in 1984. The move to restriction was
evident not only in the questionable M1 data but
in monetary base growth and rising real interest
rates. What happened, in line with Friedman’s
expectation, was a substantial slowdown in real
and nominal income growth during 1984—but,
contrary to his expectation, it commenced in
1984:Q2 and was not associated with a recession.
42

Friedman (1988, p. 229).

See Small and Porter (1989, pp. 245-46).

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Rather, the United States had a “soft landing,”
instead of an overreaction to the unsustainably
high real growth of 1984:Q1. In fact, the early-tomid 1984 period is now regarded as the pivotal
period in which the United States transitioned
to the “Great Moderation” and so a much more
stable business cycle (see, e.g., Bernanke, 2004;
Blanchard and Simon, 2001; McConnell and
Perez-Quiros, 2000; and Stock and Watson, 2002).
Based on the prior experience that Friedman had
studied, big withdrawals of monetary stimulus
implied a recession; but the 1984 episode produced an example of a better transition of the
economy from over-rapid growth.44
On top of his very public errors in forecasting
inflation and recession, 1984 proved a dismal year
for Friedman on several other fronts. His and Rose
Friedman’s television program The Tyranny of
the Status Quo (a follow-up to their 1980 success,
Free to Choose) flopped, Newsweek dropped him
as a columnist, and in October he suffered a heart
attack. In December he was able to record success
by putting things into a longer perspective, telling
the Wall Street Journal, “It’s widely accepted
that you can’t hold inflation down unless you
hold down the money supply. Thirty years ago,
people didn’t agree with that” (WSJ, 12/10/84).

The Battle of the Friedmans
In light of Milton Friedman’s awful forecasts
for 1984, finding fault with his monetary analysis
during this period should be like shooting fish
in a barrel. It happens, however, that two such
critiques, by Benjamin Friedman and Alan
Blinder, that appeared during the 1980s contain
oversights that, when corrected, lead to support
for some aspects of Milton Friedman’s analysis
during the early 1980s.
Benjamin Friedman (1988, p. 61) critically
considers Milton Friedman’s (1984b) statement
that the relation between nominal GNP and M1
growth was “unusually close” and, using 1987vintage data, states that “The GNP-to-lagged-M1
correlation was not ‘unusually close’ during
44

In addition, some of the slowdown in nominal spending was
recorded in a fall in the annual inflation rate of about 1 point over
1984 rather than slower economic growth.

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1979:Q4–1983:Q4 compared with the past…The
correlation of 0.45…is essentially identical to
that for the previous 79 quarters.”
On closer inspection, this claim of Benjamin
Friedman’s does not stand up as a refutation of
Milton Friedman, as it overlooks key elements of
what was said in the 1984 article. What Milton
Friedman (1984b, p. 399) said of M1 growth and
nominal GNP growth was “From 1981 on, the
relation is extraordinarily close—indeed, instead
of being less close than during the earlier [pre1979] years, is considerably closer…Two things
are notable…first, the lag is both shorter on the
average…second, the relation is unusually close”
(emphasis added).
In evaluating Milton Friedman’s position,
Benjamin Friedman overlooked the statement
that the claimed close relationship was from
“1981 on.” Once this aspect of Milton Friedman’s
statement is taken into account, Benjamin
Friedman’s challenge to Milton Friedman’s contention regarding the M1/nominal income relation
under the new operating procedures is refuted.
As Table 1 shows, the peak M1/future income correlation is unusually high from 1981 on (whether
1981-83 or 1981-84 is considered), compared
with pre-1979 correlations. Moreover, Milton
Friedman’s statement, ignored by Benjamin
Friedman in his calculation of correlations, that
the lag was shorter after 1979 is also supported:
The peak correlation is with a two-quarter lead
for M1 growth up to 1979, but with a one-quarter
lead for both 1979-83 and 1981-83.45 Thus, when
the sample considered is restricted to begin with
the period to which Milton Friedman explicitly
indicated that his comments pertained, Milton
Friedman’s contention that the relationship is
unusually close is confirmed, while Benjamin
Friedman’s counterclaim is rejected.
On a similar note, Blinder (1984, p. 267)
offered as evidence of a “shift in the moneyincome relationship” a table which “show[ed]
45

Benjamin Friedman’s comparison of one-quarter correlations
before and after 1979 in judging the strength of correlations across
periods thus overlooks Milton Friedman’s explicit statement that
the lag from money growth to income growth was longer before
1979. The practical effect of this is that the correlations reported
by Benjamin Friedman understate the strength of the M1/income
relationship both before and during the new operating procedures.

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Nelson

Table 1
Correlations of Nominal Income Growth and Prior M1 Growth
Using 2006 vintage of nominal GDP and M1 data
(annualized quarterly growth rates,
seasonally adjusted)
Correlation with M1 growth
In same quarter

Using Blinder (1984)
data

1960:Q1–
1979:Q3

1979:Q4–
1983:Q4

1981:Q1–
1983:Q4

1981:Q1–
1984:Q4

1981:Q1–
1983:Q1

1981:Q1–
1983:Q4

0.480

0.098

–0.196

–0.152

–0.425

–0.275

One quarter earlier

0.449

0.543

0.660

0.604

0.515*

0.669*

Two quarters earlier

0.515

0.227

0.595

0.570

0.024†

0.551†

Three quarters earlier

0.383

–0.217

–0.260

–0.155

–0.741‡

0.237‡

NOTE: *Starting in 1981:Q2; †starting in 1981:Q3; ‡starting in 1981:Q4. Blinder (1984) data measures nominal income by nominal GNP.
SOURCE: For 2006 vintage data: FRED (Federal Reserve Bank of St. Louis).

that during the nine-quarter period 1981 Q1 to
1983 Q1 there was actually a remarkably strong
negative correlation between money growth and
nominal GNP growth.” But as Table 1 shows, the
data given in Blinder (1984) again confirm the
strong positive correlation between M1 growth
and next-quarter nominal GNP growth claimed
by Friedman (1984b), for samples ending in both
1983:Q1 and 1983:Q4. The negative correlation
noted by Blinder is evident only in the contemporaneous relationship. The specific evidence
offered by Blinder in 1984 is therefore less a
demonstration of the absence of a money-income
relationship than it is confirmation of Friedman’s
(1980, p. 59) warning that “failure to allow for lags
in reaction is a major source of misunderstanding”
and of the 1997 observation of one former policymaker that “lags tend to be trivialized or ignored
in academia…Failure to take proper account of
lags is, I believe, one of the main sources of central bank error.”46
The breakdown of M1’s tight early-1980s
relationship with nominal income led Friedman
back to M2, but he conjectured that the same break
had led critics of monetarism to overemphasize
the extent to which money/income relationships
had changed in the 1980s. Friedman came to see
the closeness of M1 to GNP from 1981 as a “hot
46

Blinder (1997, p. 8).

F E D E R A L R E S E R V E B A N K O F S T. LO U I S R E V I E W

streak” that ended in 1984 and judged that M1
was, in fact, more distorted by financial innovation than other aggregates—i.e., the monetary base
and M2 (WSJ, 09/18/86; Friedman 1988, p. 224).
More generally, Friedman reaffirmed, “The relationship between the money supply and the state
of the economy has always been a loose one”
(SFC, 07/04/86).
Friedman also stressed that, while financial
deregulation had distorted monetary aggregates
such as M1, he supported deregulation. “Deregulation is good. That is the one good thing—the
only good thing, in my opinion—that has come
out of this [i.e., the inflation/disinflation experience].”47 Indeed, Friedman (1960, 1970c) had
called for the deregulation of commercial banks’
interest rates that ultimately took place in the
1980s. He did argue that the inflation and interestrate peaks in the 1970s and early 1980s had exacerbated the distortions arising from financial
regulation and thus increased the distortion to
monetary aggregates when deregulation took
place.48 He did not feel that financial regulation
was a cornerstone for control of monetary aggregates or of aggregate demand: Open market operations were sufficient for monetary control
(Friedman, 1974; FT, 02/23/87), and lack of reg47

From his July 1986 comments in Darby et al. (1987, p. 10).

Friedman (1985a, p. 59).

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ulation of financial institutions “in no way enables
them to escape the discipline of the Fed’s monetary actions” (WSJ, 06/30/75).
As shown above, the main critiques of
Friedman’s 1980s positions have their own weaknesses. Nevertheless, Benjamin Friedman (1988)
was on solid ground in his demonstration that
Milton Friedman (1984b) forecast higher inflation for 1983-85 from higher M1 growth and that
this proved very erroneous. “I’ve gone back to
using M2 and only M2,” Milton Friedman told
the present author much later. “I slid away from
the true and narrow path in the 1980s, and was
sorry for it!… I think those predictions in the ’80s
were bad, but I think on the whole my Newsweek
predictions stand up pretty well.”49

FROM VOLCKER TO GREENSPAN:
1986-92
Friedman remained a persistent critic of
Chairman Volcker, criticizing Volcker’s reappointment by President Reagan in July 1983. Speaking
in October 1983, Friedman acknowledged that
Volcker had “brought inflation down,” but maintained that it was still “not a good monetary policy” because it was so erratic.50 In early 1987,
Friedman returned to this theme, criticizing
Volcker’s current “seat of the pants” policy and
claiming of 1979-82 that “If somebody had wanted
deliberately to discredit monetarism they would
have done what Volcker did” (FT, 02/23/87).
Friedman’s relations with Volcker’s successor,
Alan Greenspan, would be vastly better. Though
Friedman had rarely mentioned Greenspan in
his writings, the two were old friends. When
Greenspan was appointed Chairman of the Council
of Economic Advisors in 1974, Friedman had
praised him as a “very good man” who would
resign on principle if there were another 1971-style
lurch to expansionary policies (CT, 07/17/74).
In turn, Greenspan in late 1986 had praised
Friedman as one of the 20th century’s major
49

Milton Friedman, interview with the author, Stanford University,
January 22, 1992.
Friedman (1985b, p. 41).

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intellects (SFC, 12/26/86). After Greenspan was
nominated as Chairman, Friedman said, “I’m a
good friend of Alan Greenspan. He’s an able person” (MINN, 06/03/87), though Friedman maintained he would still rather have the Federal
Reserve replaced by a computer. “I send my congratulations to Alan. And my sympathy” (SFC,
06/08/87).
In a 1981 appearance at a Brookings
Institution meeting, Greenspan had stressed the
value of M2 as a monetary indicator,51 and M2
did figure quite heavily in monetary policy discussions in Greenspan’s first four and a half years
as Chairman. Aside from a loosening after the
1987 stock market crash, Greenspan undertook a
moderately restrictive policy in his first two years
that saw annual M2 growth fall below 5 percent
and the federal funds rate briefly reach double
digits. Friedman approved, offering his opinion
that Greenspan “on the whole has been doing
very well” (TST, 03/11/89). As for inflation,
Friedman said that it was “likely to decline
sharply over the next several years” due to the
fall in M2 growth (WSJ, 07/05/89). At the end of
the decade Friedman’s assessment was very optimistic: “There’s no reason why the ’90s shouldn’t
be as good as the ’80s, or better. There’s no reason
we shouldn’t have a decade of rapid growth and
relatively low inflation” (TIME, 01/01/90).
Friedman’s optimism about the 1990s was
eventually vindicated in spades. But in the
interim, there was a spike in inflation in 1990 and
what Friedman in May 1992 called “three years
of stagnation”52 from mid-1989, including the
1990-91 recession. By late 1992, while noting
the achievement of low inflation, Friedman felt
that U.S. monetary policy had begun to exhibit
“perverse fine-tuning”—an inadvertently restrictive policy due to giving too little weight to low
money growth and too much weight to low
interest rates in judging conditions. Friedman
called for a more expansionary monetary policy
consistent with bringing M2 growth back inside
its announced target range. Doing so, Friedman
wrote, would mean that inflation would converge
51

See Brookings Institution (1981, p. 198).

Friedman (1992, p. ix).

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on its ideal value—“a level that would make it
irrelevant to individual and business decisions”
(WSJ, 10/23/92). This form of words describing
the ideal inflation rate was similar to those that
became prevalent among policymakers later in
the 1990s.53

ENTERING THE NEW ECONOMY:
1993-2001
In October 1993 Friedman wrote that “the
opportunities are there for the making of a second
industrial revolution” (FEER, 10/28/93)54 from
the previous decades’ breakthroughs in information and telecommunications technology. In
August 1995, however, he added his voice to
those economists expressing puzzlement that
U.S. productivity growth did not seem to have
increased in the information age (WSJ, 08/01/95).
It transpired that the U.S. productivity trend was
already undergoing an upward shift as he wrote
those words.
The mid-1990s also gave Friedman opportunities for introspection, including an appearance
on CSPAN’s program Booknotes in 1994. The
question of how many books he had written
prompted Friedman’s reflection, “Oh, I don’t
know—fifteen…[T]here’s no question that the
most influential book I’ve written is not Free to
Choose, but a book that sold probably onetwentieth as many, five percent as many copies,
namely A Monetary History of the United States,
which I wrote jointly with Anna Schwartz…A
Theory of the Consumption Function is, in my
53

Friedman had given a related formulation in 1981: “I think the best
of all worlds is one where you have no inflation and no indexation.
Indexation is not a good thing in and of itself” (NZH, 04/18/81).
In his 1992 article Friedman wrote as though the definition of price
stability he gave was also that stated by the Federal Reserve, which
is consistent with Orphanides’s (2006) tracing of this definition to
Paul Volcker.
Friedman attributed the post-1973 slowdown in economic growth
to greater government intervention in the economy since the 1960s
(NW, 08/23/82). While he believed that inflation (and false cures
for inflation) had damaged potential output, Friedman did not
believe that the restoration of low inflation would in itself restore
high growth. He said in 1982 that low growth and high inflation
were “two distinct phenomena, and monetarism is concerned only
with the inflation problem” (DS, 01/18/82; my translation) and
reaffirmed in 1987 that “it’s a great mistake to connect too closely the
level of inflation and the rate of economic growth” (JP, 11/11/87).

F E D E R A L R E S E R V E B A N K O F S T. LO U I S R E V I E W

mind, the best thing I ever did as piece of science,
[while] Monetary History is undoubtedly the
most influential, and Free to Choose is the best
selling, so they are not similarly characterized”
(BOOKN, 11/20/94).55
Friedman had predicted in early 1991 that
inflation would fall to 2 percent in coming years,
based on the low M2 growth maintained under
Greenspan (FUT, 03/01/91). In January 1998, by
which time inflation had stood at about this level
for five years, Friedman said in a television interview that “Right now, inflation is relatively low.
Alan Greenspan and the Federal Reserve have
done a good job of keeping monetary growth low
and fairly steady” (CNN, 01/23/98).
Shortly afterwards, Friedman gave a more
detailed evaluation of the Greenspan regime in
an interview for Barrons (BAR, 08/24/98). He again
praised the outcome of “the lowest and least
variable rate of monetary growth” compared with
comparable periods. But he also acknowledged
some weaknesses of M2 as an indicator during
the 1990s: “I think there is no doubt that in the
Nineties, from ’92 to ’95, around there, there was
a very sharp uptick in the velocity of M2 and that
targeting money supply at that time in a rigid
fashion would not have been a good thing to do…
I only say in retrospect that Greenspan did the
right thing in abandoning primary reliance on
M2 during that period.” While reaffirming that
“I don’t like operating through interest rates”
and restating his confidence in longer-term moneyincome relationships, Friedman said that
Greenspan had “done a very good job of threading his way through those [velocity] difficulties.”
This observation would be fleshed out in the
thermostat hypothesis that Friedman championed
in the 2000s.

The Thermostat Hypothesis
In 1966 Alan Walters, a U.K. monetarist, had
observed that “If the [monetary] authority was
perfectly successful then we should observe
variations in the rate of change of the stock of
money but not variations in the rate of change of
55

Besides Monetary History, the books Friedman was referring to
here were Friedman (1957) and Friedman and Friedman (1980).

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income…[a]ssuming that the authority’s objective is to stabilize the growth of income.”56 The
basic idea behind this statement is that if a variable Y has a stochastic relationship with a variable
X that monetary policy can affect, a policy that
stabilizes Y will lead to fluctuations in X to offset other potential sources of variation in Y. The
result will be a low empirical correlation between
X and Y, despite the two enjoying a structural
relationship.
A student of Friedman’s, Levis Kochin,
worked in the 1970s on the relevance of this idea
for money-income relations,57 while Poole (1995)
argued that roughly optimal policy since 1982
had produced low correlations between inflation
and money growth.
Friedman initially showed little interest in
ideas along these lines. He acknowledged in 1984
that successful stabilization should mean that
“high monetary variability…[is] associated with
low economic variability,” but believed that the
relevance of this was contradicted by the positive
relationship between monetary variability and
output (and nominal income) variability in the
data.58 This was, of course, in line with his longheld position that stabilization policy had often
been tried, but had proved counterproductive.
Thus in 1967 Friedman had described the Federal
Reserve’s stated aim of responding to emerging
economic conditions as “a formula guaranteed
to produce bad policy” (NW, 01/09/67) and had
written that forward-looking formulations of this
approach were likely to be destabilizing, with
policymakers “vainly trying to lean against next
year’s wind which, in the process, they are themselves stirring up” (WP, 11/05/67).
But by early 2000, however, in light of the
much-reduced degree of output variability,
Friedman had reached the view that stabilization
policy had been executed successfully by the
Federal Reserve in recent years and was a major
reason for high M2 growth variability relative to
output variability since 1992 (see Taylor, 2001).
To articulate the idea, Friedman made an anal56

Walters (1966, p. 276).

Kochin (1973); see also Kishor and Kochin (2004).

Friedman (1984a, p. 34).

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ogy between successful stabilization policy and
the behavior of a thermostat. This was a revival
of an analogy prevalent in the 1950s; for example,
a commentator on U.K. economic affairs, Anthony
Crosland, wrote in 1956 that economic policy in
practice would never achieve the ideal where
“demand could be exactly set, as though by a
thermostatic control, at just the right point.”59
U.S. monetary policy in the 1990s, as Friedman
saw it, had come closer to achieving the “thermostatic” ideal than many, including himself, had
thought practicable.
Friedman was thus able to identify a period
in which money growth targeting was inferior to
the monetary policy actually pursued. He had
always argued that this was possible in principle:
Friedman (1960, p. 98) had said that there was
“little to be said in theory” for a constant money
growth rule and “persuasive theoretical grounds”
for varying money growth “to offset other factors.”
Rather, the money growth rule recommendation
emerged from the uncertainty underlying the
policy responses required for successful stabilization, which meant that “deviations from the simple rule have been destabilizing rather than the
reverse.” Nor in later expositions did Friedman
claim that money growth targeting was optimal
in theory.60
There are some weaknesses in the thermostat
hypothesis as an explanation for shifting moneyincome relations in the data.61 For his part,
Friedman advanced the thermostat story only to
account for some of the looseness in money59

Crosland (1956, p. 398). Similarly, Warburton (1953, p. 10), in
commenting on activist rules that Friedman had advanced in the
1940s, said that they were designed to be “a self-regulating mechanism, such as a thermostat…”

For example, in Friedman (1970b, pp. 18-19) the money growth
rule was acknowledged as inferior in principle to “deliberate
changes in the rate of monetary growth…to offset other forces,”
this alternative being rejected by Friedman “until such time as we
demonstrably know enough to limit discretion by [using] more
sophisticated rules.” While usually made with nominal income
stabilization as the implicit criterion, this conclusion was also
applied to direct targeting of prices (or inflation) by Friedman
(1968b, 1982b).

For example, it does not distinguish between weak correlations
that emerge because policymakers make use of a stable structural
relationship between money and the economy and the case where
much of the weakness reflects the fact that the structural relationship is itself undergoing change.

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income relations on quarterly data; he continued
to believe that longer-period stability in nominal
income required moderate rather than high variability in money.

21st Century Developments
The U.S. stock market peaked in early 2000.
Friedman attributed some of the stock market’s
strength to higher M2 growth (WSJ, 01/22/02;
Friedman, 2005). Nevertheless, he concurred
that stock prices had far exceeded economically
justified values (FORB, 05/03/99). Thus, Friedman
noted in October 2001, the Federal Reserve faced
the issue of what to do in the aftermath of an
“excessively bullish stock market” (UPI, 10/09/01).
“The monetary policy Greenspan is following I think really has no precedent,” Friedman
remarked on this occasion, adding that he had a
“great deal of sympathy” with the interest-rate
cuts that Greenspan had initiated in January 2001.
Whether these cuts were sufficient, Friedman said,
depended on “what their effect has been on monetary growth,” though Friedman cautioned that
money growth would now be difficult to interpret
because “there’s no doubt one of the effects of
September 11 will be to increase the demand for
cash balances” (UPI, 10/09/01).62 Four years later,
Friedman (2005) reached a favorable verdict on
the period. He maintained that monetary policy
behavior, by keeping M2 growth high in the wake
of the stockmarket decline, had stopped the equity
price collapse from leading into anything more
than a shallow recession. The monetary stimulus
had also been withdrawn at “just about the rate
required for a rapidly growing non-inflationary
economy” (WSJ, 04/07/05).

“The use of quantity of money as a target has not
been a success. I’m not sure I would as of today
push it as hard as I once did” (FT, 06/07/03). To
readers of Friedman’s interviews in 1998-2000
with Barrons and John Taylor, the 2003 quotations
were not a great surprise. Friedman had previously
made it clear that he had been unhappy with how
monetary targeting had typically been implemented in practice and had been impressed by
how U.S. monetary policy in recent years had
done better on economic stabilization than he
had thought practicable and outperformed what
he would expect from a money growth rule. The
2003 remarks were not a break with his position
in these earlier interviews.
Some commentators, however, took the
remarks in isolation and interpreted the 2003
interview as repudiation by Friedman of monetarism.63 William Keegan, the economics editor
of the London Observer and a longtime critic of
Friedman’s, used the quote as the basis for an
article entitled “So Now Friedman Says He Was
Wrong” and asserted that “Friedman, now 91
[sic; 90], … feel[s] it is time to own up. It is ‘true
confession’ time” (OBS, 06/22/03). In light of this
and similar “spins” on his remarks, Friedman
decided to produce a lengthy exposition of his
interpretation of the monetary policy developments in the preceding 15 years. The resulting
article, in the Wall Street Journal, would disappoint anyone looking for confirmation that he
had turned his back on monetarism. On the contrary, while again praising recent policy for
doing better than a constant money growth rule,
Friedman maintained the following position:
“Velocity is ordinarily very stable, fluctuating
63

STILL A MONETARIST: 2002-06
In June 2003 a profile appeared in a Financial
Times magazine supplement that included brief
remarks from Friedman on monetary targeting:
62

The powerful effect of national emergencies in increasing the
demand for real money balances (equivalently, reducing velocity)
was a long-standing Friedman theme (e.g., Friedman and Schwartz,
1963, pp. 673-75; Friedman and Schwartz, 1982, pp. 4, 228;
Friedman, 1984b, p. 399).

F E D E R A L R E S E R V E B A N K O F S T. LO U I S R E V I E W

Over the years, discussions of Friedman often seized on new public
statements of his and alleged that these amounted to recanting of
previous positions. For example, a commentator reacting to a talk
Friedman gave in 1981 wrote, “Milton Friedman has made a significant change in his doctrine since his previous visit to Australia in
1975” (SML, 04/19/81). And in 1987 John Kenneth Galbraith said in
an interview, “I think Professor Friedman, who was an interesting
man, has disappeared into the shadows very much. He has accused
the Reagan Administration of prime incompetence in the managing
of economic policy” (SMH, 02/24/87). These claims of reversals in
position, like those made in 2003, were unfounded—consisting
either of incorrect readings of Friedman’s earlier statements or
illegitimate extrapolations from his later ones. Nevertheless, as
we have seen, Friedman did change his position on certain issues,
such as the relative merits of M1 and M2, and on the lag between
monetary actions and inflation.

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only mildly…The MV = Py key to a good thermostat was there all along” (WSJ, 08/19/03). Indeed,
at the time that he was working on this article,
Friedman noted to the present author:

Friedman also took the opportunity of the
Wall Street Journal article to offer a story about
why monetary policy had changed since the
inflationary 1960s and 1970s. Over the years—
in interviews he gave in the late 1980s (e.g., FT,
02/23/87; SFC, 08/18/87) and even as late as
2000 (in the Taylor interview)—Friedman had
appealed to far-fetched and unconvincing explanations for why policymakers had shifted to low
inflation. These stories centered on the political
profitability of inflation having been reduced by
indexation of tax brackets and government securities. Accounts such as this attributed too much
knowledge to pre-1980s policymakers regarding
how to control inflation.
Now, instead, Friedman returned to themes
that he had put forward during the 1970s and
early 1980s, which emphasized the errors in policymakers’ basic theories of inflation. In 2002 he
noted that policymakers in the United States and
United Kingdom “used to say inflation was caused
by trade union power, cost pressures, and so on;
nobody talks like that any more.”65 His 2003
article elaborated on this “shift in the theoretical

paradigm.” The major change since the 1970s,
Friedman now affirmed, was the shift by policymakers from adherence to cost-push views to
acceptance that inflation was a monetary phenomenon (WSJ, 08/19/03). While pleased with
this development, Friedman was unhappy with
the fact that focus on monetary aggregates had
receded. Always ready with an analogy, Friedman
had written in 1966 that discussing monetary
policy without mentioning money was like writing a book about love without mentioning sex.66
As far as current economic developments
were concerned, in 2003 Friedman dismissed
“all the talk about deflation.”67 A necessary condition for deflation, monetary contraction, had
not occurred. As for whether falling high-tech
goods prices could produce deflation, Friedman
had dismissed this back in 1978: “The high price
of cars doesn’t cause inflation any more than a
drop in the price of hand calculators causes deflation” (TDN, 05/19/78).
In December 1986 Friedman, while acknowledging some discomfort at being better known for
the likes of Free to Choose than for his monetary
economics, had foreshadowed that his research
output would dry up—“people’s capacities to do
scientific work decline with age” (SFC, 12/26/86).
As things turned out, he never could stop completely, and almost 20 years later, in August 2006,
Friedman (now age 94) was putting the finishing
touches on his latest research paper. Friedman
delivered the paper to the London, Ontario, conference by videolink from San Francisco on
August 18. The subject was tradeoffs in monetary
policy, and the paper was a contribution to a
Festschrift for Friedman’s former student David
Laidler. As noted above, Friedman had used the
thermostat hypothesis to help explain recent
money/income patterns. That hypothesis was
based on the observation that M2 variability was
high relative to output variability during the
1990s. But in reviewing the longer picture using
annual data, Friedman now stressed that the
larger event was the large reduction in the absolute
level of M2 growth variability in recent decades.

Milton Friedman, email to author, July 21, 2003.

Friedman (1966, p. 24).

Quoted in Pringle (2002, p. 15).

Milton Friedman, email to author, July 21, 2003.

In my original support for a straight money
target, I always emphasized that it was partly
a case based on ignorance, based on the fact
that we really did not understand sufficiently
well the detailed relationship between money,
income, interest rates, and the like to be able
to fine-tune, that our goal should be to develop
a detailed enough understanding so that we
could do better than a simple constant monetary growth target.
However, I believe still, as I did then, that
constant monetary growth would produce a
highly satisfactory price path, and, if it enabled
you to get rid of the Federal Reserve System,
that gain would compensate for sacrificing the
further improvement that a more sophisticated
rule could produce.64

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Figure 1
Fourteen-Quarter Moving Standard Deviation of Quarterly Annualized M2 Growth
Value
5.0
4.5
4.0
3.5
3.0
2.5
2.0
1.5
1.0
0.5
0.0
1962

1967

1972

1977

1982

1987

1992

1997

2002

NOTE: The figure is based on quarterly averages of FRED data for seasonally adjusted M2. Before calculating growth rates and standard
deviations, post-1982 observations on M2 were rescaled using the ratios implied by Friedman’s (1988, p. 240) adjustment for the
introduction of money market deposit accounts. This shift is also found to be important by Small and Porter (1989, p. 253) and Moore,
Porter, and Small (1990, pp. 59-60), and their estimate of its magnitude is similar to Friedman’s estimate.

(This is also evident in quarterly data: Figure 1
displays the 14-quarter standard deviation of
money growth, a key statistic in the FriedmanModigliani [1977] debate.) “The collapse of the
variability of output,” Friedman wrote, “is clearly
an effect of the collapse of monetary variability.
In my opinion, the same results could have been
obtained at any earlier time and can continue to
be achieved in the future.”68

CONCLUSION
Despite his prolific writing, Milton Friedman
did not provide a single, detailed record of his
views on post-1960 U.S. monetary history. He
instead relayed those views in a number of forums,
including regular and semi-regular newspaper
and magazine columns, books and articles, congressional testimony, and interviews with economists and the national and world media. The
68

Friedman (2006).

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objective of this paper has been to bring together,
using archival material from several countries,
information about Friedman’s views and predictions regarding post-1960 U.S. monetary developments and to evaluate his interpretations in light
of subsequent events. The 1960s and 1970s were
notable for policymaker resistance to, then acceptance of, Friedman’s consistently held views on
exchange rates and on the control of inflation.
Probably the most important changes in
Friedman’s outlook over the 1980s, 1990s, and
2000s were a firming of his preference for M2 as
the definition of money, following several years
of forecast errors using M1, and his concession
that stabilization policy in the United States since
the mid-1980s had been more successful than he
had thought possible. Friedman’s outlook nevertheless remained monetarist, and he continued
to advocate a fixed money growth rule, arguing
that such a constraint on policymaking was
desirable.
In addition to giving an impression of
Friedman’s perspective on monetary policy
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practice, this analysis must shed some light on
Friedman’s theoretical framework, since, as he
once said, there is always a “general economic
model which each of us must have, underlying
our specific temporal predictions.”69

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APPENDIX A
Abbreviations for Periodicals Cited in Text
BAR—Barrons (U.S.); BOOKN—Booknotes (CSPAN television program; transcript); CHA—Challenge
(U.S.); CNN—Moneyline (CNN television program; transcript); CSM—Christian Science Monitor
(Boston); CT—Chicago Tribune; DC—Daily Courier (Connellsville, PA); DFP—Detroit Free Press; DOM—
Dominion Post (Morgantown, WV); DS—Der Spiegel (Hamburg, Germany); ESN—Edmonton Sun
(Alberta, Canada); FEER—Far Eastern Economic Review (Hong Kong); FORB—Forbes magazine (U.S.);
FORT—Fortune magazine (U.S.); FT—Financial Times (London); FUT—Futures (U.S.); IT—Irish Times
(Dublin); JOH—The Star (Johannesburg, South Africa); JP—Jerusalem Post (Israel); JT—Japan Times
(Tokyo); KCS—Kansas City Star (Kansas City, MO); LAT—Los Angeles Times; MHER—The Herald
(Melbourne, Australia); MINN—Minneapolis Star-Tribune; NW—Newsweek (U.S.); NYDN—Daily News
(New York); NYP—New York Post; NYT—New York Times; NZH—New Zealand Herald (Wellington);
OAK—Oakland Tribune (Oakland, CA); OBS—The Observer (London); OKL—The Daily Oklahoman;
PHB—Philadelphia Bulletin (Philadelphia, PA); PHI—Philadelphia Inquirer; SCMP—South China
Morning Post (Hong Kong); SFC—San Francisco Chronicle; SLGD—St. Louis Globe-Democrat; SMH—
Sydney Morning Herald; SML—Sunday Mail (Brisbane, Australia); STE—Sunday Telegraph (London):
STR—Straits Times (Singapore); TDN—The Detroit News; TG—The Guardian (London and Manchester,
U.K.); TIME—Time magazine (U.S.); TSN—Toronto Sun (Ontario, Canada); TST—Toronto Star (Ontario,
Canada); TT—The Times (London); UPI—UPI news wire; USAT—USA Today; USNR—U.S. News and
World Report; WCPD—Weekly Compilation of Presidential Documents (Washington, DC); WP—
Washington Post; WSJ—Wall Street Journal (New York).

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APPENDIX B
Chronological List of Media Articles Referred to in Text
‘Lex’, “A Prosperous New Year? Equities v. Gilts for 1963,” Financial Times, December 29, 1962, p. 1.
David R. Francis, “The Economic Scene,” Christian Science Monitor, September 28, 1964, p. 10.
David M. Grebler, “Rate Hike Hailed by Top Economist,” St. Louis Globe-Democrat, December 9, 1965.
Paul A. Samuelson, “The New Economics in the U.S. Faces Some Old Problems,” Financial Times, December 31,
1965, p. 9.
“Quotable,” Chicago Tribune, May 8, 1966, p. G5.
Richard L. Strout, “Jiggle That Jolted Economists,” Christian Science Monitor, December 19, 1966, pp. 1 and 7.
Milton Friedman, “Current Monetary Policy,” Newsweek, January 9, 1967.
Milton Friedman, “Current Monetary Policy,” Newsweek, October 30, 1967.
Milton Friedman, “Taxes, Money and Stabilization,” Washington Post, November 5, 1967, pp. H1 and H3.
(Also appeared in The Banker (London), December 1968, pp. 1096-101.)
Louis Dombrowski, “Ask Money Supply Equal to Growth Rate,” Chicago Tribune, July 5, 1968, p. C8.
Paul Samuelson, “Don’t Make Too Much of the Quantity Theory,” Sunday Telegraph, December 15, 1968,
pp. 19 and 21.
“The New Attack on Keynesian Economics,” Time, January 10, 1969.
Milton Friedman, “Monetary Overkill,” Newsweek, August 18, 1969.
Albert L. Kraus, “‘Mini-Recession’ Seen,” Dominion Post, August 24, 1969, p. 3D.
Milton Friedman, “A New Chairman at the Fed,” Newsweek, February 2, 1970.
Vera Glaser, “Economist Hits Burns on Inflation Plan,” Philadelphia Inquirer, May 29, 1970.
John Maclean, “Fewer Jobs, Product Dip Called Vital,” Chicago Tribune, June 29, 1970, p. E7.
Rob Warden, “What Really Causes Inflation?” Chicago Daily News, July 29, 1970, pp. 3 and 4.
Arthur Greenspan, “Leading Economists View Nixon Freeze,” New York Post, August 16, 1971, pp. 5 and 39.
UPI, “Bretton Woods System Is Dead, Friedman Says,” Japan Times, September 24, 1971, p. 13.
Milton Friedman, “The Fed on the Spot,” Newsweek, October 16, 1972, p. 98.
Associated Press, “Economist Says Controls to Stay,” Kansas City Star, December 7, 1972, p. 2A.

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John Getze, “Managing Economy: Fed Hung on Horns of Dilemma,” Los Angeles Times, February 18, 1973,
pp. G1 and G3.
Leonard Wiener, “Freeze ‘Worst Mistake,’” Oakland Tribune, June 15, 1973, p. F17.
Milton Friedman, “The Hard Truth,” Newsweek, September 17, 1973.
“‘Good Chance of Recession,’ Milton Friedman Declares,” Philadelphia Bulletin, October 12, 1973.
UPI, “FRB’s Burns Favors Wage, Price Curbs,” Japan Times, October 15, 1973, p. 12.
“Facing Inflation—Interview: Milton Friedman,” Challenge, November/December 1973, pp. 29-37.
A. Joseph Newman Jr., “Free-Enterprise Answer to Energy Woe,” Philadelphia Bulletin, November 9, 1973.
Nick Poulos, “Political Climate Key to Greenspan Future,” Chicago Tribune, July 17, 1974, p. C7.
Robert Betts, “Experts Debate Cures for Inflation,” Daily Courier, August 16, 1974, p. 10.
Frances Cairncross, “Inflation ‘Immoral Tax No M.P. Would Approve,’” The Guardian, September 16, 1974, p. 12.
Press Association, “Inflation a Threat to Democracy—U.S. Economist,” Irish Times, September 18, 1974, p. 14.
Milton Friedman, “Who Represents Whom?” Newsweek, October 14, 1974.
Leonard Silk, “Money Growth a Puzzle,” New York Times, February 26, 1975, p. 53.
Dennis V. Waite, “A Monetarist Talks Tough on Recession,” Philadelphia Bulletin, March 2, 1975.
Milton Friedman, “Six Fallacies,” Wall Street Journal, June 30, 1975, p. 11.
Milton Friedman, “Five Examples of Fed Double-Talk,” Wall Street Journal, August 21, 1975, p. 6.
Milton Friedman, “How to Hit the Money Target,” Newsweek, December 8, 1975.
Associated Press, “Ford Promotes Speech Writer,” The Detroit News, February 5, 1976.
Associated Press, “U.S. Savings Bonds Called Ripoff,” Oakland Tribune, February 12, 1976, p. 1.
Neil Behrmann, “Friedman Doubts Quick U.S. Recovery,” The Star, April 5, 1976, p. 20.
“Friedman Takes Stanford Post,” Chicago Tribune, November 2, 1976, p. C11.
UPI, “Friedman to Be Research Fellow at Stanford’s Hoover Institution,” New York Times, November 3, 1976,
p. 23.
Louis Rukeyser, “A ‘Conservative’ Carter Predicted,” Philadelphia Bulletin, November 15, 1976.
Jerome Idaszak, “Friedman Says We Asked for Inflation,” Philadelphia Bulletin, November 18, 1976.
Milton Friedman, “To Jimmy from James,” Newsweek, December 6, 1976, p. 45.

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“Names and Faces,” Detroit Free Press, December 25, 1976, p. 15A.
Milton Friedman, “Behind the Unemployment Numbers,” Newsweek, February 7, 1977, p. 63.
“Where Carter Is Going Wrong: Interview with Nobel Prize Winner Milton Friedman,” U.S. News and World
Report, March 7, 1977, p. 20.
Milton Friedman, “Why Inflation Persists,” Newsweek, October 3, 1977.
Donald C. Bauder, “Economist Assails Growth in Monetary Aggregates,” St. Louis Globe-Democrat, December 7,
1977.
David M. Grebler, “Friedman Is Optimistic About Public’s Economic Understanding,” St. Louis Globe-Democrat,
December 16, 1977.
Milton Friedman, “Inflationary Recession,” Newsweek, April 24, 1978, p. 81.
Walter B. Smith, “Take Mild Recession Now, or Worse Later, Economist Forecasts,” The Detroit News, May 19,
1978.
AAP, “Economist Points to U.S. Recession,” The Herald, May 22, 1978, p. 20.
Milton Friedman, “Money Watchers Beware,” Newsweek, October 30, 1978, p. 62.
Milton Friedman, “Volcker’s Inheritance,” Newsweek, August 20, 1979.
Timothy C. Gartner, “Why Americans ‘Like Inflation,’” San Francisco Chronicle, October 18, 1979, p. 31.
Milton Friedman, “Our New Hidden Taxes,” Newsweek, April 14, 1980.
Milton Friedman, “Monetary Overkill,” Newsweek, July 14, 1980.
Milton Friedman, “Marx and Money,” Newsweek, October 27, 1980.
Colin Larsen, “Friedman Advises ‘Don’t Blame the Politicians for Everything,’” New Zealand Herald, April 18,
1981, p. 12.
H.W. Herbert, “A Change in Milton Friedman,” Sunday Mail, April 19, 1981, p. 22.
Glen Bayless, “Economist Raps Federal Reserve,” Daily Oklahoman, May 19, 1981, p. 86.
Harrison Rainie and James A. White, “Friedman: Kill the Fed,” Daily News, May 22, 1981, p. 38.
Milton Friedman, “Reaganomics and Interest Rates,” Newsweek, September 21, 1981, p. 27.
Ronald Reagan, “Remarks and a Question-and-Answer Session at a Working Luncheon with Out-of-Town
Editors, October 16, 1981,” Weekly Compilation of Presidential Documents transcript;
www.presidency.ucsb.edu.
Wolfgang Kaden and Walte Knips, “‘Das Ganze Sozialsystem Ist Falsch’: Der Ökonomie-Nobelpreisträger
Milton Friedman über die Amerikanische und Britische Wirtschaftspolitik,” Der Spiegel, January 18, 1982,
pp. 109-16.

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Milton Friedman, “The Yo-Yo Economy,” Newsweek, February 15, 1982.
“Friedman Predicts Fall in Inflation Rate to 6pc,” Straits Times, February 19, 1982.
Milton Friedman, “An Aborted Recovery?” Newsweek, August 23, 1982.
Bjorn Tretvoll, “Oil Could Fall to US$10 a Barrel—Friedman,” South China Morning Post, September 17, 1982,
p. B8.
Maxwell Newton, “Hokum Marks Fed Policy Switch,” New York Post, October 12, 1982.
Peter Brimelow, “Economics’ Latest Messiah,” Edmonton Sun, October 21, 1982, p. 11.
Milton Friedman, “The Needle Got Stuck,” Newsweek, July 25, 1983, p. 4.
UPC, “Top Economist Predicts: More Inflation in ’84,” Toronto Sun, August 30, 1983.
Milton Friedman, “Why a Surge of Inflation Is Likely Next Year,” Wall Street Journal, September 1, 1983, p. 24.
Thomas C. Hayes, “Reagan Preoccupies Economic Meeting,” New York Times, December 31, 1983, pp. 29-30.
Walter Guzzardi Jr., “The Dire Warnings of Milton Friedman,” Fortune, March 19, 1984, pp. 20-25.
Michael Quint, “Money Data Backed as Gauge,” New York Times, April 30, 1984, p. D7.
Lindley H. Clark, Jr. and Laurie McGinley, “Money’s Role: Monetarists Succeed in Pushing Basic Ideas But Not
Their Policies,” Wall Street Journal, December 10, 1984, pp. 1 and 16.
Gerald M. Connors, “Some Good Things Do Last,” Daily News, November 13, 1985, p. 58.
Daniel Rosenheim, “Sprinkel Questions Reliability of M1,” San Francisco Chronicle, July 4, 1986, p. 33.
Milton Friedman, “M1’s Hot Streak Gave Keynesians a Bad Idea,” Wall Street Journal, September 18, 1986, p. 32.
Jonathan Peterson, “Defining Friedman Takes a Lifetime,” San Francisco Chronicle, December 26, 1986, pp. 39
and 41.
Milton Friedman, “Monetary History, Not Dogma,” Wall Street Journal, February 12, 1987, p. 24.
Anatole Kaletsky, “Freedom Rules, OK: Anatole Kaletsky Talks to Milton Friedman, Father of Monetarism,”
Financial Times, February 23, 1987, p. 12.
Kenneth Davidson, “J.K. Galbraith and the New Economics,” Sydney Morning Herald, February 24, 1987, p. 15.
Mike Meyers, “Fed Chairman Wields Power by Influence,” Minneapolis Star-Tribune, June 3, 1987.
“Milton Friedman Says He’d Dump the Fed,” San Francisco Chronicle, June 8, 1987, p. 23.
Maxwell Newton, “U.S. Notebook: Economic Figures Knock the Optimism,” The Times, July 20, 1987.
Arthur M. Louis, “Milton Friedman Optimistic on Long-Term Inflation,” San Francisco Chronicle, August 18,
1987, p. 52.

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Daniel Doron, “ ‘Is the Private Sector Really Privatized?’: Part Five of an Interview with Prof Milton Friedman,”
Jerusalem Post, November 11, 1987.
Milton Friedman, “Money and Economy: The Twain Do Meet,” Wall Street Journal, June 22, 1988, p. 25.
Louis Rukeyser, “Economist Friedman Gives High Praise to Greenspan,” Toronto Star, March 11, 1989, p. B2.
Milton Friedman, “Whither Inflation?” Wall Street Journal, July 5, 1989.
Otto Friedrich, “Freed From Greed?” Time, January 1, 1990.
Debra Sherman, “Nobel Laureate Discounts Impact of War on U.S. Economy,” Futures, March 1, 1991, p. 56H.
Milton Friedman, “Too Tight for a Strong Recovery,” Wall Street Journal, October 23, 1992, p. A12.
Milton Friedman, “The Second Industrial Revolution,” Far Eastern Economic Review, October 28, 1993, p. 23.
Brian Lamb, “Interview with Milton Friedman: Introduction to the Fiftieth Anniversary Edition of F.A. Hayek’s
Road to Serfdom,” Booknotes (CSPAN television program), telecast November 20, 1994 (transcript).
Milton Friedman, “Getting Back to Real Growth,” Wall Street Journal, August 1, 1995, p. A14.
Lou Dobbs, “IMF Bailout: Interview with Milton Friedman,” Moneyline (CNN television program), telecast
January 23, 1998 (transcript).
Gene Epstein, “Mr. Market: A Nobelist Views Today’s Fed, Currencies, Social Security, Regulation,” Barron’s,
August 24, 1998, p. 30.
Peter Brimelow, “Bubblenomics,” Forbes, May 3, 1999, p. 138.
Ian Campbell, “Friedman Opposes Stimulus Package,” UPI, October 9, 2001.
Milton Friedman, “Follow the Money,” Wall Street Journal, January 22, 2002.
Simon London, “Lunch with the FT—Milton Friedman: The Long View,” Financial Times (Financial Times
Magazine supplement, Issue No. 7), June 7, 2003, pp. 12-13; ft.com: June 5, 2003.
William Keegan, “So Now Friedman Says He Was Wrong,” The Observer, June 22, 2003, Business section, p. 7.
Milton Friedman, “The Fed’s Thermostat,” Wall Street Journal, August 19, 2003, p. A8.
Milton Friedman, “No Cause to Berate Fed for ‘Reigniting Inflation,’” Wall Street Journal, April 7, 2005.
Bill Nichols and Tom Vanden Brook, “Tributes Pour In for Ford,” USA Today, December 27, 2006, pp. 1A-2A.

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F E D E R A L R E S E R V E B A N K O F S T. LO U I S R E V I E W

The Lower and Upper Bounds of the
Federal Open Market Committee’s
Long-Run Inflation Objective
Daniel L. Thornton
It is widely acknowledged that the Fed can control the average inflation rate over a period of time
reasonably well. Because of this and the Federal Open Market Committee’s (FOMC’s) long-standing
commitment to price stability, the author argues that the FOMC has an implicit long-run inflation
objective (LIO)—lower and upper bounds to the long-run inflation rate. He shows that the statements made by the FOMC in 2003 clarified the lower bound of its LIO and that the average of
long-run inflation expectations responded by rising about 80 basis points. Moreover, consistent
with reducing the market’s uncertainty about the FOMC’s LIO, long-run inflation expectations
became more stable. The FOMC has recently been more specific about the upper bound of its LIO
as well. The FOMC could eliminate the remaining uncertainty by establishing an explicit, numerical
inflation objective. (JEL E50, E52, E58)
Federal Reserve Bank of St. Louis Review, May/June 2007, 89(3), pp. 183-93.

urrently there are at least 21 countries
with inflation targets.1 Inflation targeting is marked by a numeric inflation
objective that the central bank attempts
to achieve over a reasonably well-specified time
horizon. The numeric target is most often a range
in which inflation is permitted to vary over a
multiyear horizon. Among the industrialized
nations of the world, the central banks of the
United States and Japan stand out in not adopting a formal, numeric inflation target.
Economists and policymakers have raised a
number of objections to establishing an explicit
numeric inflation target in the United States. The
most important of these objections are discussed
in Federal Reserve Bank of St. Louis (2004) and,
hence, will not be discussed here. When he was
1

See Rasche and Williams (2005) for a list of these countries and
the details of their inflation targets.

a Federal Reserve System Governor, Bernanke
(2004) suggested that the Fed take an “incremental
move toward inflation targeting, in the form of
the announcement of a long-run inflation objective”2 (LIO), which I take to be congruent with
Bernanke’s optimal long-run inflation rate, which
he defined as “the long-run (or steady-state) inflation rate that achieves the best average economic
performance over time with respect to both the
inflation and output objectives.”3 I argue that (i)
the Federal Open Market Committee (FOMC)
already has what can be reasonably characterized
as an implicit LIO and (ii) having an implicit LIO
is a consequence of the conventional wisdom that
the Fed (indeed, all central banks) can control
the long-run inflation rate. I present evidence
2

Bernanke (2004, p. 165).

Bernanke (2004, p. 166).

Daniel L. Thornton is a vice president and economic advisor at the Federal Reserve Bank of St. Louis. Daniel McDonald provided research
assistance.

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that the market believes that the FOMC has an
implicit LIO by showing the market’s reaction to
statements made by the FOMC in 2003.
The adoption of inflation targeting by many
of the world’s central banks is directly linked to
changing views about the central bank’s ability to
control inflation. The now conventional wisdom
that the Fed and other central banks control longrun or steady-state inflation is the primary reason
central banks have an explicit or implicit LIO.
Hence, the paper begins with a brief review of the
evolution of thinking about the ability of central
banks to control inflation during the nearly 100
years of the Federal Reserve System.

CENTRAL BANKS AND INFLATION
Although it is now widely believed that the
FOMC has an implicit LIO, this has not always
been the case. Indeed, there has been an ebb and
flow in economists’ and policymakers’ thinking
about the ability of the central bank to control
inflation over the near 100 years of the Federal
Reserve System. The quantity theory of money
was the dominant theoretical paradigm in the
economics profession at the time of the Fed’s
founding. The quantity theory was embodied in
the gold standard, where long-run price stability
was maintained through an automatic equilibrating process known as the price-specie-flow mechanism. In essence, the quantity theory asserts a
strong causal link between money growth and
inflation. In fiat monetary systems, where the
currency is not backed by gold or other precious
metals, the quantity theory asserts that central
banks control inflation by controlling the rate of
growth of the money supply. Permitting the money
supply to grow more rapidly than is warranted
by labor force and productivity growth causes
inflation. Too slow money growth results in
deflation. The quantity theory hypothesizes that
inflation is always and everywhere a monetary
phenomenon that central banks can control.
The early Fed was skeptical of the quantity
theory and followed what is called the real bills
doctrine. The real bills doctrine hypothesized
that reserves supplied by the Fed for “productive
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purposes”—to enhance the production of goods
and services—would not be inflationary.
Economists’ thinking about what central
banks could and could not do about inflation
changed markedly following the publication of
Keynes’s The General Theory of Employment,
Interest and Money in 1936 and the subsequent
Keynesian Revolution. For various reasons, perhaps the most important of which were concerns
that the central banks had limited ability to control the supply of money and the belief that the
demand for money was not stable, economists
and policymakers came to question central banks’
ability to control (or even substantially influence)
inflation. The conventional wisdom was that
inflation was not the consequence of an excess
supply of money, but of an excess of aggregate
demand—the demand for all goods and services—
which could occur independent of the relative
supply of money.4 Moreover, it was believed that
monetary policy had relatively little impact on
aggregate demand.5 A small effect on aggregate
demand translates into a small effect on inflation.
Consequently, it was thought that the Fed could
do relatively little to control inflation.
A high point of the belief that inflation is not
a monetary phenomenon in the United States
occurred in 1974 with the federal government’s
WIN (Whip Inflation Now) campaign. The WIN
campaign was an attempt to spur a grassroots
movement to reduce inflation through a combination of public and private measures to reduce
aggregate demand and, consequently, “demandpull” inflation. Fiscal policy, increased saving,
and other factors—not monetary policy—were
thought to be the keys to curing the nation’s
inflation woes.6
The monetarist counterrevolution and the
success with anti-inflation monetary policy in
4

See Nelson (2005a,b) and Nelson and Nikolov (2004) for a discussion of how neglect of monetary factors and belief that other factors
caused inflation played a role in several of the great inflations of
the 1970s.

See Bernanke (1993) for an excellent and concise discussion of
some of these arguments.

On this note it is interesting to observe that inflation has been
trending lower despite a corresponding negative trend in the
United States saving rate.

F E D E R A L R E S E R V E B A N K O F S T. LO U I S R E V I E W

Thornton

the late 1970s and early 1980s dramatically
changed economists’ and policymakers’ thinking
about what central banks could do about inflation.7 Despite the fact that the Fed and nearly all
other central banks now use a short-term nominal
interest rate instrument and not monetary aggregates to conduct policy, it is widely acknowledged
that central banks can control inflation on average
over a period of time.8
If central banks can control the average longrun inflation rate, it follows that they are responsible for it, whether they, or the governmental
agencies to whom they report, establish a specific
numerical objective for it or not or whether, by
their actions, they effectively abdicate their
responsibility: The Fed was responsible for the
great inflation of the 1970s, even though it was
not intended. For most central banks, the realization that they control the long-run inflation rate
has led to the adoption of formal inflation objectives or inflation targets. Although it has never
adopted a specific inflation target, the Fed has
had a long-standing objective of “price stability.”
Former Chairman Greenspan repeatedly noted
that the primary role of monetary policy is to
promote sustainable economic growth over time
by fostering price stability.9 Chairman Bernanke
has reiterated the causal link between price stability and economic growth, noting that “price
stability is essential for strong and stable growth
of output and employment.”10 Given the belief
that the Fed can control the long-run inflation
rate and its stated objective of price stability, it
follows that the FOMC has an implicit LIO.11
That is, the FOMC has an implicit range of inflation that is consistent with its objective of “price
stability.”
Despite his repeated assertion that sustainable
economic growth is inexorably linked to price
7

See Federal Reserve Bank of St. Louis (2005) for a detailed discussion and analysis of this period in U.S. monetary policy.

See Bernanke (2003) for a discussion of the role of money and
monetary aggregates in the inflation process.

See Rasche and Thornton (2006) for more details.

Bernanke (2006).

For example, Yellen (2005) notes that “inflation…is what the Fed
can undeniably control in the long run.”

F E D E R A L R E S E R V E B A N K O F S T. LO U I S R E V I E W

stability, former Chairman Greenspan opposed
adopting a specific numerical LIO on the grounds
that no price index adequately reflected price
stability and because of political concerns
(Greenspan, 2002; FOMC, 1995). In contrast,
Chairman Bernanke has been a steadfast proponent of inflation targeting (e.g., Bernanke, 2002,
2003, 2004). Several other FOMC participants
also have expressed a preference for announcing
an explicit LIO recently (e.g., Poole, 2006; Lacker,
2005; Stern, 2005; and Yellen, 2006).

DOES THE MARKET BELIEVE
THE FOMC HAS A LIO?
Given the belief that the Fed is responsible
for the average long-run inflation rate and the
FOMC’s commitment to price stability, it is reasonable to assume that market participants have
a perception of the FOMC’s implicit LIO. For
example, it is doubtful that anyone believes that
the FOMC would be content with long-run inflation of 5 percent or with persistent and protracted
deflation. Hence, it seems safe to assert that most
market analysts believe that the FOMC’s implicit
LIO is somewhere between zero and, say, a maximum of 5 percent. Of course, some may believe
the implicit target to be narrower. Assuming that
market participants expect the FOMC to behave
consistently with its implicit LIO, the average of
these expectations provides a point estimate of
the FOMC’s implicit LIO.
The only market-based measure of inflation
expectations is the spread between Treasury
inflation-indexed securities (TIIS) and the corresponding non-indexed Treasury issue. TIIS are
indexed to inflation as measured by the consumer
price index (CPI). Nominal long-term bond yields
reflect both the market’s expectation for the real
yield and expectations for inflation, whereas the
corresponding TIIS reflects only the real yield;
accordingly, the TIIS spread—the difference
between the nominal yield and the corresponding
TIIS yield—is, in principle, a measure of the
market’s expectation of inflation over the holding
period of the long-term asset. The spread is not a
pure measure of inflation expectations because
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Figure 1
10-Year TIIS Spread (monthly average)
3.50
3.00
2.50
2.00
1.50
1.00
0.50
0.00
Jan
97

Jan
98

Jul
97

Jul
98

Jan
99

Jul
99

Jan
00

Jul
00

Jan
01

Jul
01

the spread also may reflect risk and liquidity
premiums.12 That is, the spread is equal to

TIIStsp = π e + rp − lp,
where TIIStsp denotes the spread between nominal
and inflation-indexed Treasury securities, π e
denotes expected inflation, rp denotes the inflation risk premium, and lp denotes the liquidity
premium.
The possibility of a non-zero inflation risk
premium arises from the fact that investors in
nominal debt are uncertain about the inflation
rate that will occur over the holding period of
the assets. This is due in part to uncertainty about
the FOMC’s LIO. Of course, no one expects the
FOMC to achieve its LIO exactly at each point in
time. Consequently, the inflation risk premium
might exist because of stochastic variation in
inflation around a known LIO. Either way, the
greater the uncertainty, the more investors will
have to be compensated—the larger the risk premium—assuming that investors are risk averse.13
12

Also, it is impossible to match the maturities of TIIS and nominal
government securities exactly. Even if the maturities were an exact
match, the two securities have different payment flows. See Sack
and Elsasser (2004) and Kwan (2005) for additional details.
Even if investors were risk neutral, the risk premium would not
vanish for technical reasons; see Sack (2000) and Sack and
Elsasser (2004) for details.

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Jan
02

Jul
02

Jan
03

Jul
03

Jan
04

Jul
04

Jan
05

Jul
05

Jan
06

Jul
06

The liquidity premium stems from the fact
that the market for TIIS is less liquid than the
market for nominal Treasury securities. Consequently, TIIS investors likely receive a liquidity
premium in the form of a higher return for holding TIIS rather than more-liquid conventional
securities.
The risk and liquidity premiums have opposing effects on the spread as a measure of inflation
expectations. The existence of a risk premium
causes TIIStsp to overestimate the market’s expectation for inflation. The existence of a liquidity
premium causes TIIStsp to underestimate inflation
expectations. Consequently, TIIStsp only approximates CPI inflation expectations. Nevertheless,
if one is willing to assume that the sum of these
premiums is relatively stable over time, marked
changes in the TIIS spread should reflect changes
in market participants’ expectations of inflation.
Inflation-indexed securities were first issued
in January 1997. Figure 1 presents the monthly
on-the-run TIIStsp for 10-year government securities since January 1997.14 TIIStsp fluctuated considerably during the early years of the market
14

On-the-run securities are the most recent issue. The on-the-run
spread reported here is obtained by subtracting the yield on the
most recently issued TIIS from the constant maturity yield on the
most recently issued nominal Treasury security that most closely
matches the maturity of the on-the-run TIIS.

F E D E R A L R E S E R V E B A N K O F S T. LO U I S R E V I E W

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but settled down by early 2001. From January
2001 to June 2003, TIIStsp averaged 1.72 percent.
In the summer of 2003 the spread began to widen,
but by January 2004 it appeared to have settled
down again. From January 2004 to March 2006,
the spread averaged 2.49 percent, 77 basis points
higher than from January 2001 to June 2003. What
is responsible for the widening of the spread?

The 2003 Experience
At the conclusion of the May 2003 meeting,
the FOMC stated in its press release that “the
probability of an unwelcome substantial fall in
inflation, though minor, exceeds that of a pickup
in inflation from its already low level.” This statement was widely analyzed in the press as suggesting the possibility that inflation was at the “lower
bound” of the rate acceptable to the Committee.
This interpretation was reinforced by the release
of the minutes of the May meeting on June 25
and by the FOMC’s June 2003 press release. The
minutes indicated that “substantial additional
disinflation would be unwelcome because of the
likely negative effects on economic activity and
the functioning of financial institutions and markets, and the increased difficulty of conducting
an effective monetary policy, at least potentially
in the event the economy was subjected to adverse
shocks.”15 Members agreed, however, that “there
was only a remote possibility that the process of
disinflation would cumulate to the point of a
decline for an extended period in the general
price level.”16 The June press release contained
a statement identical to the May statement, but
went on to indicate that, “On balance, the
Committee believes that the latter concern [an
unwelcome fall in inflation] is likely to predominate for the foreseeable future.”
15

Minutes of the Federal Open Market Committee, May 2003. The
last concern is reference to the so-called zero bound problem. The
zero bound problem arises because zero is the theoretical lower
bound to nominal interest rates. Because the policy instrument is
the nominal federal funds rate, the zero bound on nominal interest
rates is thought by some to set a lower bound to the FOMC’s ability
to conduct expansionary monetary policy. For a more detailed
discussion of the zero bound problem, see Bernanke (2002).

Minutes of the Federal Open Market Committee, May 2003.

F E D E R A L R E S E R V E B A N K O F S T. LO U I S R E V I E W

Then-Governor Bernanke detailed his views
in a speech entitled “An Unwelcome Fall in
Inflation?” on July 23, 2003. Noting that “the
May 6 statement was more than a procedural
innovation,” Bernanke suggested that it “broke
new ground as the first occasion in which the
FOMC expressed the concern that inflation might
actually fall too low.”17 Bernanke’s suggestion
that the FOMC had a non-zero lower bound
beyond which it did not want inflation to fall
was made clear in the FOMC’s August 12 statement, which read, “The Committee judges that,
on balance, the risk of inflation becoming undesirably low is likely to be the predominant concern
for the foreseeable future” (emphasis added). This
statement was repeated in the September 16 and
October 28 statements.
That the 2003 experience effectively established a lower bound for the FOMC’s LIO is also
suggested by Jeffrey Lacker, president of the
Federal Reserve Bank of Richmond, who was the
Director of Research at the Richmond Fed in 2003.
Lacker (2005, p. 6) notes that
The statement issued following the May 2003
FOMC meeting asserted that a fall in inflation—
then about 1 percent—would be “unwelcome.”
This came as something of a surprise to
markets and caused a sharp reaction in longterm rates. If an inflation target range had been
in place in 2003 with a lower bound of 1 percent, the public could have inferred the Fed’s
growing concern about disinflation as the
inflation rate drifted down toward that bound...
If the May 2003 statement is interpreted as the
revelation of the lower bound of an inflation
target range, then half of an inflation target
range has been announced. And if revealing a
dislike of inflation below 1 percent was useful
in May 2003, is it not likely that revealing an
upper bound will prove useful in some future
circumstance?

The FOMC’s concern about disinflation began
to abate in the fall of 2003. At the conclusion of
the December meeting the FOMC indicated that
“the probability of an unwelcome fall in inflation
has diminished in recent months and now appears
almost equal to that of a rise in inflation.” Refer17

Bernanke (2003).

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Figure 2
5-Year TIIS Spread (monthly average)
3.50
3.00
2.50
2.00
1.50
1.00
0.50
0.00
Jan May Sep Jan May Sep Jan May Sep Jan May Sep Jan May
02 02 02 03 03 03 04 04 04 05 05 05 06 06

ence to an unwelcome fall in inflation was not
mentioned in subsequent statements.

The Effect of the 2003 Experience on
Market Participants’ Beliefs about the
FOMC’s LIO
Market participants formulate their beliefs
about the FOMC’s implicit LIO from verbatim
FOMC transcripts, minutes of FOMC meetings,
press releases made at the conclusion of each
FOMC meeting, speeches and other statements
made by the Chairman and other FOMC participants, and FOMC policy actions. It is not surprising that there was a sharp change in the TIIS spread
following the FOMC’s revelations concerning the
lower bound of its implicit inflation objective.
If the observed rise in the 10-year TIIS spread
were due to the market having better information
about the FOMC’s LIO, we might anticipate that
expectations would be revised at a horizon that
might reasonably be thought of as the horizon
consistent with the FOMC’s LIO. Consequently,
TIIStsp is also calculated for the 5-year horizon.
Figure 2 presents TIIStsp using the 5-year TIIS
beginning in October 2004 and the previous 10year issues that are closest to having a 5-yearremaining term for the previous period. Because
the first 10-year TIIS was first issued in 1997, the
sample period is January 2001 through August
2006. The behavior of the 5-year TIIStsp after the
2003 experience was similar to that of the 10-year
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TIIStsp. Specifically, the average 5-year TIIStsp
increased by about 100 basis points, from 1.46
percent for the period January 2002 through June
2003 to 2.48 percent for the period January 2004
through April 2006.
If the marked rise in long-run inflation expectations shown in Figures 1 and 2 is due to the
FOMC eliminating some uncertainty about the
lower bound of its long-run inflation objective,
we might also expect to see a reduction in the
variability of the TIIS spread. That this occurred
is verified in Figure 3, which shows the intramonth standard deviation of the 10-year (solid
line) and 5-year (dashed line) TIIS spreads using
daily data. Despite the fact that the average level
rose, consistent with long-run inflation expectations being more precisely held, there is a marked
drop in the intra-month standard deviation in
early 2004 for both the 5-year and 10-year TIIS
spreads. For the 10-year TIIStsp, the standard
deviation declined from 7 basis points from
January 2001 through June 2003 to 5 basis points
from January 2004 though August 2006. For the
5-year TIIStsp, the standard deviation dropped by
a third, from 9 basis points for the period January
2002 through June 2003 to 6 basis points from
January 2004 though August 2006.

Survey Measures of Long-Run Inflation
The Blue Chip and Michigan survey also poll
their survey participants for inflation forecasts
over longer-run horizons. The Blue Chip survey
is biannual, while the Michigan survey is monthly.
The Michigan survey asks respondents what they
believe will be the average CPI inflation rate over
the next 5 to 10 years, whereas the Blue Chip forecasts are for 5-year and 10-year horizons. The
monthly average of the mean forecast of Michigan
survey for the period 1997-2006 are presented in
Figure 4. The qualitative implications from the
Blue Chip survey are identical, so only the
Michigan survey is presented here. Survey expectations drifted down slightly from early 1997 to
early 2001; however, unlike TIIStsp there is no
marked change in the survey forecasts of the longterm inflation rate after mid-2003. Survey forecasts for long-run inflation averaged 3.3 percent
for both the period January 2001 through June
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Thornton

Figure 3
Intra-Month Standard Deviation of the 5- and 10-Year TIIS Spreads
0.30
5-Year
0.25

10-Year

0.20
0.15
0.10
0.05
0.00
Jan
97

Jul
97

Jan
98

Jul
98

Jan
99

Jul
99

Jan
00

Jul
00

Jan
01

Jul
01

Jan
02

Jul
02

Jan
03

Jul
03

Jan
04

Jul
04

Jan
05

Jul
05

Jan
06

Jul
06

Figure 4
The Survey of Inflation Over the Next 5 to 10 Years
4.5
4.0
3.5
3.0
2.5
2.0
1.5
1.0
0.5
0.0
Jan May Sep Jan May Sep Jan May Sep Jan May Sep Jan May Sep Jan May Sep Jan May Sep Jan May Sep Jan May Sep Jan May
97 97 97 98 98 98 99 99 99 00 00 00 01 01 01 02 02 02 03 03 03 04 04 04 05 05 05 06 06

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2003 and January 2004 though July 2006. Hence,
the indication from TIIStsp—that there was a
marked change in inflation expectations in the
wake of the FOMC being more explicit about its
LIO—is not reflected in survey expectations
measures.
The lack of response of the survey forecasts
after May 2003 is difficult to reconcile with the
marked and sustained increase in the TIIS inflation expectations measure. It could be that there
was a marked increase in the liquidity premium
in the TIIS market that just happened to coincide
with the FOMC’s statements. The liquidity premium between on-the-run nominal Treasuries and
the less liquid on-the-run TIIS is not directly
observable. However, comparisons of yields of
on-the-run and off-the-run TIIS indicate that the
liquidity premium for on-the-run TIIS is small
and does not decline markedly in mid-2003.
Estimates of the liquidity premium in the nominal
Treasury market by Gurkaynak, Sack, and Wright
(2006) also suggest that the liquidity premium is
rather small, about 10 basis points. Hence, it is
unlikely that the approximately 80-basis-point
widening of the spread could be attributed solely
or largely to a decline in the liquidity premium.
Alternatively, statements made at the May
and subsequent meetings could have caused the
inflation risk premium to rise. For example, some
market participants who thought that the FOMC’s
inflation target range was say 0 to 2 percent may
have become more uncertain about the FOMC’s
LIO. More generally, indications that the FOMC
had a non-zero lower bound to acceptable inflation could have shaken some participants’ belief
about the FOMC’s commitment to price stability.
That the entire 80-basis-point increase can be
attributed to a larger inflation risk premium seems
unlikely, however.
Despite the fact that there is no corresponding
rise in survey measures of inflation expectations,
the fact that TIIStsp widened following the FOMC’s
statements and leveled off when the FOMC indicated that its concerns about disinflation had
waned strongly suggests that the sharp rise in
TIIStsp reflects the market’s reevaluation of the
FOMC’s implicit LIO. One possibility is that the
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FOMC’s statements effectively truncated the lower
end of the probability distribution of inflation
expectations. That is, consistent with Lacker’s
(2005) interpretation, individuals who may have
thought the Fed’s inflation objective was less than,
say, about 1 percent revised their expectation
upward. This explanation alone would not seem
to account for the 80-basis-point rise in the spread.
To see why, assume that prior to the summer of
2003 all market participants thought that the
FOMC’s LIO was 0 to 3 percent, with a mean of
1.5 percent (which is close to the average spread
from January 2001 through June 2003). If the
statements caused all market participants simply
to truncate their estimate of the lower bound of
the FOMC’s LIO at 1 percent, this would cause
the average spread to increase by only 50 basis
points, from 1.5 percent to 2 percent. It is, however, difficult to assess the impact of truncation
on the average level of inflation expectations
because the FOMC was vague about the lower
bound for inflation. Some market participants
may have thought that the effective lower bound
was now higher than the 1 percent rate suggested
by Lacker. Nevertheless, if the nearly 80-basispoint rise in the spread is entirely due to a rise
in inflation expectations among market participants, it would seem that the FOMC’s statements
must have caused some market participants to
raise their estimate of the upper bound of the
implicit LIO as well. For example, participants
who previously thought the FOMC’s target range
was 0 to 2 percent could have raised the estimated
range to 1 to 3 percent.

The Upper Bound of the FOMC’s LIO
Statements made in 2003 suggest that the
FOMC has a lower bound of acceptable long-run
inflation in the neighborhood of 1 percent. Given
its commitment to price stability, there can be no
doubt that the FOMC has an upper bound as well.
However, as Bernanke (2004) has noted, the publicly expressed preferences for the LIO by various
members of the FOMC range “from less than 1
percent to 2.5 percent or more.”18 With the recent
18

Bernanke (2004, p. 165).

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rise in inflation, the FOMC has provided more
information about the upper bound of its implicit
LIO. The minutes of the August 9, 2005, FOMC
meeting indicate that
While recent monthly readings indicated that
core inflation had been subdued, a number of
participants noted that underlying core inflation appeared to be running at a pace around
the upper end of the range they viewed as consistent with price stability—an assessment that
was reinforced by the recent upward revisions
to historical data on core PCE inflation. Participants commented that an increase in inflation
from recent rates could have especially adverse
effects on longer-run economic performance.
(emphasis added)

A similar statement appeared in the minutes
of the March 27-28, 2006, FOMC meeting, where
Some participants held that core inflation
and inflation expectations were already toward
the upper end of the range that they viewed
as consistent with price stability, making them
particularly vigilant about upside risks to inflation, especially given how costly it might be
to bring inflation expectations back down if
they were to rise. (emphasis added)

A similar statement appeared in the minutes
of the May 10, 2006, meeting.
The minutes of June 28-29, 2006, meeting are
more specific in that they indicate that inflation
may have already reached the Committee’s
upper bound. The minutes note that
All participants found the elevated readings on
core inflation of recent months to be of concern
and, if sustained, inconsistent with the maintenance of price stability. (emphasis added)

During the three months prior to this meeting,
annual core CPI inflation averaged about 3.75
percent, while core PCE inflation averaged about
3.1 percent. The lack of specificity about the core
measure to which the FOMC was referring creates
uncertainty about the upper bound of the FOMC’s
inflation objective. Nevertheless, if these numbers
reflect “core inflation of recent months,” the
upper bound of the FOMC’s LIO is somewhere
in the neighborhood of 3.1 to 3.75 percent.
F E D E R A L R E S E R V E B A N K O F S T. LO U I S R E V I E W

If one assumes that Lacker’s suggestion that
the 2003 experience established the lower bound
of the FOMC’s implicit LIO at 1 percent, one can
conjecture that the FOMC’s implied LIO is, say, 1
to 3.5 percent. The midpoint of this range, 2.25
percent, is very close to Chairman Bernanke’s
(2004, p. 166) suggestion that “something in the
vicinity of 2 percent is the optimal long-run
average inflation rate for a variety of assumptions
about the costs of inflation, the structure of the
economy, the distribution of shocks, etc.”
Bernanke noted, however, that many details
would have to be decided before such a number
could be embraced by the FOMC and suggested
that additional research would be worthwhile
before the FOMC could decide on the optimal
long-run inflation rate. The estimate of 2.25 percent is below the TIIS spread of 2.5 percent, but
the difference can easily be accounted for by a
non-zero inflation risk premium.

CONCLUSIONS
Because the Fed can control the average longrun inflation rate and because of the FOMC’s
long-standing commitment to price stability, it
is reasonable to assume that the FOMC has an
implicit LIO. The 2003 experience clarified the
lower bound of the FOMC’s LIO. The minutes of
June 2006 have clarified the FOMC’s upper
bound. That this recent guidance does not appear
to have affected the TIIS spread significantly suggests that the information merely reinforced the
market’s belief in the upper bound of the FOMC’s
LIO. The FOMC could alleviate the remaining
uncertainty by following Bernanke’s (2002) suggestion and formally announcing a LIO. Until it
does, the market will have to rely on FOMC statements, actions, and other information to pin it
down more tightly.

REFERENCES
Bernanke, Ben S. “Credit in the Macroeconomy.”
Federal Reserve Bank of New York Quarterly
Review, Spring 1993, 18(1), pp. 50-70.

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Bernanke, Ben S. “Deflation: Making Sure ‘It’ Doesn’t
Happen Here.” Remarks before the National
Economists Club, Washington, DC, November 21,
2002.
Bernanke, Ben S. “An Unwelcome Fall in Inflation?”
Remarks before the Economics Roundtable,
University of California at San Diego, La Jolla,
California, July 23, 2003.
Bernanke, Ben S. “Panel Discussion: Inflation
Targeting.” Federal Reserve Bank of St. Louis
Review, July/August 2004, 86(4), pp. 165-68.
Bernanke, Ben S. Semiannual Monetary Policy
Report to the Congress, February 15, 2006.
Federal Open Market Committee. Transcript of the
January 31–February 1, 1995, meeting. Washington,
DC: Board of Governors of the Federal Reserve
System.
Federal Reserve Bank of St. Louis. Inflation
Targeting: Prospects and Problems. Proceedings of
the Twenty-Eighth Annual Economic Policy
Conference of the Federal Reserve Bank of St.
Louis, Federal Reserve Bank of St. Louis Review,
July/August 2004, 86(4), pp. 3-184.
Federal Reserve Bank of St. Louis. Reflections on
Monetary Policy 25 Years After October 1979.
Federal Reserve Bank of St. Louis Review,
March/April 2005, 87(2), Part 2, pp. 137-358.
Greenspan, Alan. “Chairman’s Remarks.” Federal
Reserve Bank of St. Louis Review, July/August
2002, 84(4), pp. 5-6.
Gurkaynak, Refet S.; Brian, Sack and Wright,
Jonathan H. “The U.S. Treasury Yield Curve: 1961
to the Present.” Finance and Economic Discussion
Series 2006-28, Board of Governors of the Federal
Reserve System, 2006.
Kwan, Simon. “Inflation Expectations: How the
Market Speaks.” Federal Reserve Bank of San
Francisco Economic Letter, October 3, 2005, No.
2005-25, pp. 1-3.
Lacker, Jeffery M. “Inflation Targeting and the
Conduct of Monetary Policy.” Speech at the

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University of Richmond, Richmond, Virginia,
March 1, 2005.
Nelson, Edward. “Monetary Policy Neglect and the
Great Inflation in Canada, Australia, and New
Zealand.” International Journal of Central Banking,
June 2005a, 1(1), pp. 133-79.
Nelson, Edward. “The Great Inflation of the
Seventies: What Really Happened?” Advances in
Macroeconomics, July 2005b, 5(1), Article 3.
Nelson, Edward and Nikolov, Kalin. “Monetary
Policy and Stagflation in the UK.” Journal of
Money, Credit, and Banking, June 2004, 36(3), pp.
293-318.
Poole, William. “Inflation Targeting.” Federal
Reserve Bank of St. Louis Review, May/June 2006,
88(3), pp. 155-64.
Rasche, Robert H. and Thornton, Daniel L.
“Greenspan’s Unconventional View of the LongRun Inflation/Output Trade-Off.” Federal Reserve
Bank of St. Louis Monetary Trends, January 2006.
Rasche, Robert H. and Williams, Marcela M. “The
Effectiveness of Stabilization Policy.” Bank of
Korea International Conference 2005, Federal
Reserve Bank of St. Louis Working Paper, 2005048B, 2005.
Sack, Brian. “Deriving Inflation Expectations from
Nominal and Inflation-Indexed Treasury Yields.”
Board of Governors of the Federal Reserve System,
Finance and Economics Discussion Series,
Working Paper 2000-33, 2000.
Sack, Brian and Elsasser, Robert. “Treasury InflationIndexed Debt: A Review of the U.S. Experience.”
Federal Reserve Bank of New York Economic
Policy Review, May 2004, 10(1), pp. 47-63.
Stern, Gary H. “Top of the Ninth: Formalizing the
Success of Past Policy.” Federal Reserve Bank of
Minneapolis The Region, June 2005;
www.minneapolisfed.org/pubs/region/05-06/
top9.cfm.

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Yellen, Janet L. “Challenges for Policymaking in a
Changing Global Economy.” Speech presented to
the Bank of Korea’s International Conference 2005,
Seoul, Korea, May 27, 2005.
Yellen, Janet L. “Enhancing Fed Credibility.” Speech
presented at the Annual Washington Policy
Conference of the National Association of Business
Economists, Washington, DC, March 13, 2006.

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F E D E R A L R E S E R V E B A N K O F S T. LO U I S R E V I E W

Granger Causality and
Equilibrium Business Cycle Theory
Yi Wen
Postwar U.S. data show that consumption growth “Granger-causes” output and investment growth,
which is puzzling if technology is the driving force of the business cycle. The author asks whether
general equilibrium models with information frictions and non-technology shocks can rationalize
the observed causal relationships. His conclusion is they cannot. (JEL E13, E32)
Federal Reserve Bank of St. Louis Review, May/June 2007, 89(3), pp. 195-205.

here is a “causal” relationship among
consumption, output, and investment.
Postwar U.S. data show that consumption growth “Granger-causes” gross
domestic product (GDP) growth but not vice
versa and that GDP growth in turn Grangercauses business investment growth but not vice
versa.1 This unidirectional causal chain suggests
that consumption contains better information
about the source of shocks hitting the economy
than does output, and output in turn contains
better information about such shocks than does
investment.
This causal relationship cannot be explained
by standard real business cycle (RBC) models.
For example, under technology shocks, output
contains the best information possible for the
source of shocks; hence, it will not appear to be
“Granger-caused” by consumption once the history of output is taken into account. To rationalize
the causal relationship found in the U.S. data, it
seems natural to consider demand shocks and to
add a richer information structure into standard
models such that demand shocks can affect consumption before affecting output and investment.2
1

The concept of causality is defined according to Granger (1969).

I investigate whether existing equilibrium
business cycle models driven by demand shocks
(in particular, government spending shocks) can
rationalize the observed causal relationship when
the following information structure is embedded:
(i) Employment and output cannot respond to
demand shocks immediately; they can do so only
with a lag behind consumption. And (ii) investment cannot respond to demand shocks immediately; it can do so only with a lag behind output.3
Under these ad hoc assumptions, I first show
that standard general equilibrium business cycle
models do predict the existence of a causal chain
from consumption to output and investment,
but with the wrong sign. Namely, consumption
growth negatively causes output growth, and output
2

Hall (1978) first points out that consumption appears to be exogenous with respect to output and investment. More recently,
Cochrane (1994) argues that the predictive power of consumption
on output indicates that consumption shocks are important for
the business cycle.

The rationale could be time-to-build or adjustment costs in
employment and investment. Notice that preference shocks do
not resolve the problem because under preference shocks consumption is not able to respond at the impact period when neither output nor investment can respond to the shocks. Consequently,
consumption would contain the same information as output and
would fail to Granger-cause output.

Yi Wen is a senior economist at the Federal Reserve Bank of St. Louis. The author thanks Mike Dueker, Nubo Kiyotaki, Mike Pakko, Karl Shell,
Neil Wallace, and the seminar participants at the Cornell/Penn State Macro Conference (2002) for comments. Luke Shimek provided
research assistance.

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growth in turn negatively causes investment
growth.4 In the U.S. data, however, these causal
relationships are strictly positive. The negative
causal chain emerges from standard models
because of the crowding-out effect among components of aggregate demand in general equilibrium.
I then choose to mitigate the crowding-out
problem by allowing for variable capacity utilization and production externalities in standard models, following Baxter and King (1990),
Benhabib and Farmer (1994), Burnside and
Eichenbaum (1996), Wen (1998), and Benhabib
and Wen (2004). Variable capacity utilization
and mild production externalities mitigate the
crowding-out problem by creating short-run
increasing returns to labor, which permit the
expansion of output to meet aggregate demand
with little increase in marginal costs in the short
run. These modifications, however, bring about
only limited success. The model now predicts
that output growth positively causes investment
growth, but it fails to predict that consumption
growth positively causes output growth. The
source of failure is still the crowding-out effect:
Demand shocks crowd out consumption at the
impact period during which neither output nor
investment is able to respond.
There seem to be no simple remedies for the
problems identified. More fundamental modifications to existing models are required to fully
explain the causal aspects of the business cycle
in general equilibrium. One possible remedy is to
allow for inventory accumulation, so as to further
mitigate the crowding-out effect on consumption.
Because general equilibrium business cycle
models with inventories are still at an early stage
of development, this channel is left as a future
research topic.5

I first estimate the following equations by ordinary
least squares6:
(1)

∆y t = f ( ∆y t −1, ∆y t −2 ),

(2)

∆y t = f ( ∆y t −1 , ∆y t − 2 , ∆it −1 ),

(3)

∆y t = f ( ∆y t −1, ∆y t −2 , ∆ct −1 ),

where ∆y is growth in real GDP, ∆i is growth in
business fixed investment, and ∆c is growth in
real consumption of nondurable goods and services. A variable x is said to Granger-cause a variable y when a prediction of y on the basis of its
history can be improved by further taking into
account the previous period’s x. Estimating (1),
(2), and (3) gives the following results (t-values
are in parentheses, the 5 percent significance level
[denoted throughout by an asterisk] is ±1.96):
(4)

∆y t = 0.005 + 0.29∆y t −1 + 0.12∆y t −2 ,
(6.1
18)* (4.36)*
(1.80)
(5)
∆y t = 0.005 + 0.37∆y t −1 + 0.16∆y t − 2 − 0.05∆ it −1 ,
(5.20)* (4.59)*
(2.27)*
(− 1.79)
(6)
∆y t = 0.003 + 0.14∆y t −1 + 0.12∆y t −2 + 0.39 ∆c t −1.
(2.84)* (1.83)
(1.81)
(3.13)*
These results lead to the following conclusions: First, based on regressions (4) and (5), I
cannot reject the null hypothesis that investment
growth in the preceding period has no explanatory power with respect to output growth in the
current period, given the history of output growth.
6

THE CAUSAL RELATIONSHIPS
To document the causal relationships among
aggregate consumption, output, and investment,
4

In the rest of the paper, “cause” and “Granger-cause” are used
interchangeably.

For the recent development in the inventory literature, see Khan
and Thomas (2004) and Wen (2005a).

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The data used are quarterly U.S. data (1947:Q1–2006:Q1). Aggregate output is measured as real GDP minus inventory investment.
Inventory investment is excluded from output to highlight the
issues addressed in this paper. Namely, if demand shocks are the
driving force of the business cycle, inventories would contain the
most updated information about consumption movement and may
thus mask the causal link from consumption to output. Aggregate
consumption is measured as total consumption of nondurable
goods and services. Aggregate investment is measured as business
fixed investment. All data are taken from the Bureau of Economic
Analysis. The growth rate is defined as the first difference in logs.
Only two lags are included in the regressions because adding more
lags does not change the results significantly. For example, similar
results are obtained when four lags are used.

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Second, regressions (4) and (6) suggest that past
growth in consumption has a significant effect
on current output growth even after the history
of output growth is taken into account. In fact,
consumption growth is such an important factor
for determining future output growth that none
of the dependent variables in regression (4) remain
significant after past consumption growth is taken
into account in regression (6). This result suggests
consumption growth explains the bulk of future
output growth.
For the reversed questions, whether past output growth has an effect on current investment
growth given the history of investment growth
and whether it also has an effect on current consumption growth given the history of consumption growth, I obtain the following results:
(7)
∆ it = 0.006 + 0.39∆ it −1 + 0.04∆ it −2 ,
(3.6
64)* (5.99)*
(0.54)

(8)
∆ it = 0.0001 + 0.18∆ it −1 + 0.08∆ it −2 + 0.99∆y t −1 ,
(0.03)
(2.14)*
(1.17)
(3.93)*
(9)

∆c t = 0.006 + 0.21∆c t −1 + 0.09∆c t − 2 ,
(7.8
84)* (3.22)*
(1.40)
(10)
∆ct = 0.006 + 0.17∆ct −1 + 0.08∆ct −2 + 0.04∆y t −1 .
(7.88)* (2.16)*
Ä Ä (1.12)Ä Ä
(0.85)
Regressions (7) and (8) suggest that past output growth has a significant effect on current
investment growth. On the other hand, regressions
(9) and (10) suggest that consumption growth in
the preceding period is the best predictor of consumption growth in the current period. Taking
into account past output growth does not improve
the prediction statistically and economically.
This is consistent with Hall’s (1978) empirical
analysis that the history of consumption is the
best predictor of future consumption, except that
consumption does not follow a pure random walk.
These results suggest the existence of a oneway “causal” linkage among consumption, output,
and investment growth. Namely, consumption
growth in the preceding period Granger-causes
F E D E R A L R E S E R V E B A N K O F S T. LO U I S R E V I E W

output growth in the current period; and output
growth in the current period in turn Grangercauses investment growth in the next period. To
conclude that the causal chains are truly unidirectional, however, I must run two more regressions to eliminate the possibility of feedback from
investment growth to consumption growth. I
obtain the following results:
(11)
∆ct = 0.006 + 0.20∆ct −1 + 0.08 ∆ct − 2 + 0.01∆it −1,
(7.84)* (2.89)*
Ä Ä (1.16)Ä Ä
(0.79)
(12)
∆ it = −0.0015 + 0.33∆ it −1 + 0.03∆ it −2 + 1.05∆ct −1 .
(− 0.49) (4.95)*
Ä Ä (0.51)
(3.11)*
Regression (11) suggests that investment
growth in the preceding period has no explanatory power for consumption growth in the current
period, given the history of consumption growth.
This establishes the one-way causal chain. Regression (12) simply confirms that the causal relationships are transitive; namely, if past consumption
growth causes current output growth and past
output growth causes current investment growth,
then past consumption growth must also be significant in predicting current investment growth.

ROBUSTNESS
The standard Granger causality test gets into
trouble when a time series has a moving average
component that is not invertible. In that case,
finite history of that time series can never be sufficient for predicting its current behavior, rendering
other variables significant in improving the prediction. For example, let

x t = εt − εt −1 ,
zt = 0.9zt −1 + ε t ,
where ε t is an i.i.d. white noise innovation. If
one defines the current information set as
Ω t = {ε t , ε t –1, ε t –2 , …}, then the prediction,
P [xt|Ω t –1], cannot be improved by further taking
into account the history of zt , {zt –1, zt –2 , …}.
Strictly speaking, therefore, these two series, xt
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and zt , do not cause or predict one another. History of zt , however, can appear to be significant
in predicting the current movement of xt in the
linear regression:

causality between these other variables and the
first time series.
If we apply this idea to the above example,
regressions based on Monte Carlo simulations give
the following results (t-values are in parentheses):

x t = α + ∑γ j x t − j + β zt −1, 0 < k < `.

x t = ε t − 0.999εt −1 + ut ;
( − 2146.9)*

j =1

This is so because zt–1 contains the entire
history of innovations {ε t –1, ε t –2 , …} useful for
predicting {xt–k–1,xt–k–2,…}, which are useful
for predicting xt when only the finite history,
{xt–1,…,xt–k }, is included in the information set
of the regression.
As a demonstration, a Monte Carlo experiment of the above series gives the following estimation results:
(13)

xt =
0.0003 − 0.79x t −1 − 0.59 x t −2 − 0.40x t −3 − 0.19x t − 4
(0.03)Ä Ä Ä Ä Ä (− 80.5)* (− 49.0)* (− 33.3)* (− 19.5)*
xt =
−0.0008 − 0.76 x t −1 − 0.54x t −2 − 0.36x t − 3 − 0.17x t − 4 − 0.16zt −1 .
(−
− 0.07) ( − 82.0) * ( − 48.0) * ( − 31.5) * ( − 17.8) * ( − 34.8) *

Although cor (xt , xt –j ) = 0 for j ≥ 2, the first
regression in (13) shows xt–j are highly significant
in predicting xt even for j > 2. This happens
because xt does not have a finite autoregressive
representation when its moving average component is not invertible. Failing to take into account
the non-invertible moving average component
can render other variables such as zt –1 significant
in predicting xt , although the variable zt contains
no better information than what is in xt regarding
εt . The second regression in (13) confirms that
zt –1 is highly significant in predicting xt . Even
though the history of xt predicts xt reasonably
well (R2 = 0.39), past zt improve the prediction
(R2 = 0.46).
A sensible solution for this pitfall is to use a
two-stage regression: Fit an optimal ARMA(p,q)
model to a stationary time series, and then regress
the estimated residual from the ARMA(p,q) model
against the history of other variables that are of
interest. If these other variables appear to be significant in predicting movements in the estimated
residual series, then there is said to exist Granger
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(14)

ut = −0.02 − 0.006zt −1 ;
(0.03)Ä Ä Ä Ä Ä (–0.48
8).
As expected, the results show that past zt are
not significant in predicting current xt after the
moving average component of xt is taken into
account.
This point is relevant to my analyses of the
U.S. data because the first differences of output,
consumption, and investment could contain moving average components that are not invertible
when the log levels of these variables are not
exactly random walk series. In such cases, consumption growth in the previous period can
appear to be significant in predicting output
growth in the current period even when in fact
it does not contain any information superior to
that in output. This point is also relevant to my
theoretical analysis in what follows because the
growth rates of output and other variables in the
models have a moving average component.
With this extended notion of Granger causality in mind, I reexamine the identified causal
relationship by estimating an ARMA(4,1) model
for the growth rate of each of the three macro variables. I find that the moving average coefficients
for all three variables are highly significant and
are all close to 1 in absolute value. I then use the
estimated residuals obtained from each ARMA
estimation in a second-stage regression with
respect to a constant and the lagged growth rate
of another variable. For the case of output growth,
I obtain results, as show in Table 1, in the secondstage estimation.
The second-stage regression shows that the
estimated residual of output growth obtained from
the ARMA model is not exogenous with respect
to consumption growth in the preceding period.
Namely, consumption growth in the preceding
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Wen

Table 1

Table 2

Generalized Granger Test for ∆yt

Generalized Granger Test for ∆ct

Independent variable

Coefficient

t-Value

Independent variable

Coefficient

t-Value

∆ct–1

0.58

3.83*

∆yt–1

0.001

0.04

∆it–1

0.03

1.08

∆it–1

0.02

1.55

period helps predict current output growth even
after the history of output growth and the moving
average bias are taken into account. This is consistent with the earlier results obtained above:
Consumption growth causes output growth.
Similarly, I cannot reject the null hypothesis that
investment growth in the preceding period has no
explanatory power with respect to output growth
in the current period (see the bottom row in
Table 1). This is also consistent with the results
obtained earlier: Investment growth does not
cause output growth.
With respect to consumption growth, I obtain
the results shown in Table 2 in the second-stage
estimation. It is also consistent with earlier results
that neither output growth nor investment growth
in the preceding period has explanatory power
for consumption growth. The second-stage regression of investment growth gives the results in
Table 3.
The table shows that investment growth in
the current period is predictable by consumption
growth in the preceding period. This is also consistent with the earlier result. Output growth in
the preceding period, however, lost its significance in predicting current investment growth at
the 5 percent significance level. It is, however, still
significant at the 10 percent significance level.
In addition, judged by the economic significance,
past output growth still helps predict current
investment growth very well. The coefficient of
∆yt –1 in the regression is 0.30 with a standard
error of 0.18.
In sum, taking into account the potential bias
caused by non-invertible moving average components in the growth rates does not change the
conclusions I drew earlier: Postwar U.S. aggregate
data exhibit a “causal” chain among consumption,
output, and investment. That “causality” runs in
F E D E R A L R E S E R V E B A N K O F S T. LO U I S R E V I E W

Table 3
Generalized Granger Test for ∆it
Independent variable

Coefficient

t-Value

∆ct–1

0.95

2.59*

∆yt–1

0.30

1.61

only one direction: from consumption growth to
output growth and from output growth to capital
formation. Within this causal chain, the impact
of consumption growth on both output and
investment growth appears to be very powerful
and highly robust.
These results reinforce the empirical findings
by Hall (1978) and Cochrane (1994). They suggest
that there exist certain types of shocks in the U.S.
economy that affect consumption before having
any impact on output and investment. These
shocks cannot be total factor productivity shocks,
as output would react immediately to productivity
shocks and it is unlikely that consumers are better
informed of these shocks than firms. For this
reason, in what follows, I try to rationalize the
documented empirical regularity by introducing
information frictions and demand shocks. However, to be convincing, I first present results
obtained in standard models under technology
shocks.

PREDICTIONS OF A STANDARD
RBC MODEL
A simple RBC model can be cast in the following form in which a representative agent
solves
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Table 4
RBC Model (t-values in parentheses)
Equation for ∆yt

Equation for ∆it

Equation for ∆ct

∆ct–1 0.04 (0.73)

∆ct–1 0.24 (1.13)

∆yt–1 0.00 (0.09)

∆it–1 0.00 (0.03)

∆yt–1 0.01 (0.30)

∆it–1 0.00 (0.10)

 ` j
nt1++jγ
max
Et  ∑ β log(ct + j ) − a
1+γ
{kt+ j +1 ,ct + j ,nt+ j }  j = 0





subject to

ct + j + kt +1+ j − (1 − δ )kt + j ≤ At + j ktα+ j nt(1+−j α )
and k0 > 0. In equilibrium, consumption, output,
and investment in a RBC model should follow
these decision rules near the steady state:

ct = π ck kt + π cA At ,
y t = π yk kt + π yA At ,
it = π ik kt + π iA At ,
kt +1 = π kk kt + π kA At ,
where k is the capital stock and A is technology.
Utilizing the law of motion for the capital stock,
the above equilibrium decision rules can be further expressed as

ct = π kk ct −1 + π cA At + (π ck π kA − π cAπ kk )At −1,

assumption technology shocks follow the process
At = ρAt –1 + ε t . Because the equilibrium law of
motion for {c, y, i } suggests that the growth rates
of all variables follow an ARMA(1,1) process if
ρ = 1 and an ARMA(2,1) process if ρ = 0.9, they
all contain moving average components. I therefore apply the two-stage regression procedure
discussed in the previous section to estimate
causal relationships among the growth rates of
the three variables. In the first stage, I apply an
ARMA(2,1) model to obtain the residual series.
The estimated residuals from the ARMA(2,1)
model are then used in the second-stage regression
to determine the presence of Granger causality.
The results obtained are noted in Table 4.7
The table shows that none of the variables
Granger-cause each other once its own history is
taken into account. The coefficients are all statistically insignificantly different from zero. This is
expected because all variables in the model
share the same information about technology
shocks. Hence, adding other variables to the
regressions does not improve the prediction.

y t = π kk y t −1 + π yA At + (π yk π kA − π yAπ kk )At −1,
it = π kk it −1 + π iA At + (π ik π kA − π iAπ kk )At −1 .
Clearly, these equilibrium laws of motion
imply that consumption, output, and investment
all contain the same information about the history
of technology shocks, hence neither variable
should appear to Granger-cause another variable.
For example, once the history of output is taken
into account, consumption in the previous period
should have no additional explanatory power on
current output.
To confirm this, I simulate the model to obtain
artificial data series for consumption, output, and
investment (sample size = 10,000), under the
200

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PREDICTIONS WITH SEQUENTIAL
INFORMATION STRUCTURE
This section embeds a sequential information
structure into the benchmark model so as to create
information differentials among output, consumption, and investment. To create an information
differential between output and consumption so
that consumption contains better information
7

The time period is one quarter and the model’s parameters are
calibrated as follows: the time discounting factor β = 0.99, the
capital’s share α = 0.3, the rate of capital depreciation δ = 0.025,
the inverse labor supply elasticity γ = 0 (Hansen’s [1985] indivisible
labor), and the persistence parameter ρ = 0.9. The results are not
sensitive to these parameter values.

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than output, we need shocks that can affect consumption without affecting output in the initial
period. This suggests we need to consider demand
shocks instead of technology shocks.8 Hence I
make the following assumptions: (i) The source
of the business cycle is from aggregate demand,
and demand shocks can affect consumption
instantaneously. (ii) Decisions about employment
must be made one period in advance; this implies
that output cannot respond to demand shocks
immediately, but only with a lag behind consumption. (iii) Investment decisions must be made two
periods in advance; this implies that firms’ investment cannot respond to demand shocks immediately, but only with a lag behind output.
Under these assumptions, the representative
agent’s problem is to solve

cost and benefit of investment based on time t – 2
information; and the last equation is the periodby-period resource constraint.
In equilibrium, consumption, output, and
investment in the model should follow the following rules9:

ct = c ( kt, At, At −1, At −2, gt , gt −1, gt −2 )
y t = y ( kt, At , At −1, At −2, gt −1, gt −2 )
it = i ( kt, At −2, gt −2 ) .

where the first equation equates the marginal
utility of consumption to its shadow price; the
second equation equates the expected marginal
cost and benefit of hours based on time t – 1 information; the third equation equates the expected

These equilibrium policy rules imply that
consumption in the preceding period (ct –1) helps
predict output in the current period (yt ) even after
the history of past output, {yt–1,yt–2,…}, is taken
into account. This is so because ct –1 has information about the demand shock gt–1 that is useful for
predicting yt but is missing in the history of yt .
They also imply that output in the preceding
period (yt –1) helps predict investment in the current period (it ) even after the history of investment, {it–1,it–2,…}, has been taken into account,
because yt –1 has information about the demand
shock gt –2 that is useful for predicting it but is
missing in the history of it . Notice that this information structure cannot be obtained under technology shocks because by definition technology
shocks affect output directly before they can affect
consumption. Therefore, in the following simulations only government shocks are used.
Using similar estimation procedures above,
I obtain the results shown in Table 5 from the
second-stage regressions.10
The first column of the table shows that consumption growth in the preceding period has
significant explanatory power for the residual of
output growth in the current period. The middle
column of the table shows that output growth
(as well as consumption growth) in the preceding
period has significant explanatory power for the
residual of investment growth in the current
period. The last column of the table shows that
neither output growth nor investment growth in
the preceding period has significant effects on

See Wen (2005b) for details.

The steady-state government spending–to-output ratio is set at
g /y = 0.15.



 `
nt1++jγ

max Et − 2  max Et −1  max Et  ∑ β j log(ct + j ) − a
1+γ
n
c
{kt+1+ j }
 { t + j }  j = 0
 { t + j }

  
 
  

subject to

ct + j + gt + j + kt +1+ j − (1 − δ )kt + j ≤ At + j ktα+ j nt(1+−j α ) ,
and k0 > 0. I also assume that government spending follows an AR(1) stochastic process in logs,
log gt = 0.9 log gt –1 + εt , where the innovation εt
is i.i.d. white noise.
The first-order conditions with respect to
choices in time periods t ≥ 0 are given by

1
− λt = 0
ct

{

}

Et −1 antγ − (1 − α )λt At ktα nt(1−α )−1 = 0

{

}

E t − 2 λt − βλt +1 α At ktα+−11nt(1+−1α ) + 1 − δ  = 0
ct + g t + kt +1 − (1 − δ )kt =

At ktα nt(1−α ) ,

Technology shocks directly impact output. Hence, output always
contains the best information possible under technology shocks,
and, consequently, it is impossible for consumption to Grangercause output under technology shocks.

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Table 5
RBC Model with Sequential Information
Equation for ∆yt

Equation for ∆it

Equation for ∆ct

∆ct–1 –0.27* (–125.2)

∆ct–1 –0.15* (–79.0)

∆yt–1 0.03 (1.42)

∆it–1 –0.00

∆yt–1 –0.66* (–378.1)

∆it–1 0.07* (2.31)

(–0.03)

the residual of consumption growth in the current
period. (Although the coefficient on ∆it –1 is
statistically significant, it is economically
insignificant.)
Hence, introducing the sequential information
structure and demand shocks brings the standard
RBC model into closer conformity with the data’s
causal structure. However, the model fails on two
grounds: (i) The causal relationships among consumption, output, and investment are of the wrong
sign—they are all negative in the model. (ii) The
order of the relative volatilities of consumption,
output, and investment is exactly opposite to
that of the data: In the model, consumption is
more volatile than output, which in turn is more
volatile than investment. Both failures are due to
the well-known crowding-out effect of government shocks, which renders consumption and
output to be negatively correlated and prevents
consumption from smoothing when government
expenditure fluctuates. This crowding-out problem cannot be resolved by introducing different
forms of demand shocks, such as preference
shocks.

PREDICTIONS OF A SCALEECONOMY MODEL
Because allowing for demand shocks in the
standard models creates the well-known problem of negative comovement among components
of aggregate demand, I introduce further modifications into the model to mitigate the crowdingout problem, following the ideas of Wen (1998)
and Benhabib and Wen (2004). In the model,
output is produced according to the technology
α (1+ η )

y t = (et kt )
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2007

nt(1−α )(1+ η) ,

where e is the rate of capital utilization and η > 0
measures the degree of externalities taken as parametric by representative agents. The rate of capital
depreciation is linked to the rate of capital utilization in the preceding period according to

δt = θ1 etθ−1 (θ > 1),
implying that capital depreciates faster when
used more intensively. Thus, the law of motion
for capital accumulation is given by

(

)

kt +1 = it + 1 − θ1 etθ−1 kt .

Under these assumptions, the representative
agent’s problem is to solve


 `
nt1++jγ
max Et −2  max E t −1  max E t  ∑ β j log(ct + j ) − a
1+ γ
n ,e
c
{kt +1+ j }
 { t + j }  j = 0
 { t + j t + j }

  

  

subject to
ct + j + gt + j + kt +1+ j − (1 − δ t + j )kt + j ≤ (et + j k t + j )α (1+η )nt(1+−j α )(1+η) ,
1
δ t + j = etθ+ j −1, θ > 1;
θ

and k0 > 0,1 > e–1 > 0.11
Variable capacity utilization and mild externalities can mitigate the crowding-out effect, as
shown by Benhabib and Wen (2004). The scale
economy model therefore improves the previous
models substantially in explaining the observed
Granger causalities. Applying the two-stage estimation procedures to the model gives the results
shown in Table 6.12
11

See Wen (2005b) for details of how to solve this model.

The steady-state rate of capital depreciation is set at δ = 0.025,
which implies the utilization elasticity of depreciation θ = 1.4.
Following Wen (1998) and Benhabib and Wen (2004), I chose the
externality parameter η = 0.15. The results are not sensitive to
these parameter values.

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Table 6
Scale Economy Model with Sequential Information
Equation for ∆yt
∆ct–1 –0.02*

(–2.74)

∆it–1 –0.03* (–21.1)

Equation for ∆it
∆ct–1

3.08* (100.3)

∆yt–1 0.01

∆yt–1

1.15*

∆it–1 –0.00 (–0.70)

The scale economy model improves the performance of the previous models along several
dimensions. First, the middle column of Table 6
shows that both consumption growth and output
growth in the scale economy model positively
cause investment growth. Secondly, the first column of Table 6 shows that the negative causal
relationship found between consumption growth
and output growth in the previous models is no
longer economically significant in the scale economy model, although it is still non-positive.
Another significant improvement of the current
model is that the relative volatilities among consumption, output, and investment are restored
to the right order; namely, consumption is now
the least volatile and investment the most volatile
in the scale economy model. This smoothing
effect is explained by Wen (1998). Capacity utilization and production externalities help smooth
consumption because they render the real wage
relatively smooth compared with employment.
What has prevented the model from generating a positive causal relationship between consumption growth and output growth? Figure 1
shows the impulse responses of the model to a
positive government shock. On impact, consumption decreases significantly, whereas the other
variables remain intact. Although consumption
starts to rise above the steady state once employment and output are able to adjust in the following periods, the magnitude is relatively small
because of consumption smoothing. Thus, the
growth rate of consumption is significantly negatively autocorrelated in artificial time series of
consumption generated by government shocks,
whereas the growth rates of the other variables
are all positively autocorrelated. This negative
autocorrelation of consumption growth is caused
by the crowding-out effect of government shocks
F E D E R A L R E S E R V E B A N K O F S T. LO U I S R E V I E W

Equation for ∆ct

(35.5)

(1.29)

at the impact period, during which output and
investment are both fixed. As long as output is
not allowed to respond to shocks at the impact
period, such a crowding-out effect is unavoidable.

REMARKS
It is important to reiterate that adding technology shocks into the model does not help resolve
the problem, because the causal relationships
found in the data are conditional predictions.
What matters is the information differential
between consumption and output. Technology
(or any other) shocks will have no effect on the
causal chain unless they can change the information differential. Even though technology shocks
can create positive correlation between consumption and output, this has nothing to do with conditional predictions. Just as one time series leading
another does not imply it also Granger-causes the
other time series, a positive correlation between
consumption and output does not imply consumption Granger-causes output. This is why
simulations with mixed shocks are not considered. Also, adding other forms of demand shocks
(such as taste shocks and sunspots shocks) does
not change the fundamental picture because,
given our framework, these shocks all have a
crowding-out effect either on consumption or on
investment at the impact period when output in
the resource constraint is not able to react to
shocks. In fact, if investment is also fixed in the
initial period, then consumption is not going to
be responsive at all to preference (or sunspot)
shocks on impact; consequently, consumption
will fail to Granger-cause output. In this case, the
model is able to generate positive correlations
between consumption growth and output growth
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Figure 1
Impulse Responses of the Scale Economy Model to Demand Shocks
Impulse Response of Y

0.6

Impulse Response of C

0.06
0.02

0.5

–0.02

0.4
0.3

–0.10
0.2
0.1

–0.18

0.0
–0.1

–0.26
0

Impulse Response of I

2.2

0.5

1.4

0.4

1.0

0.3

0.6

0.2

0.1

–0.2

0.0

–0.6

–0.1

–1.0

Impulse Response of N

0.6

1.8

–0.2
0

under preference or sunspot shocks, but it still
cannot make consumption Granger-cause output.
This suggests that the concept of Granger causality
adds additional restrictions on economic theory
and is thus a powerful litmus test for equilibrium
business cycle models.

CONCLUSION
The U.S. data suggest a “causal” relationship
among consumption, output, and investment.
This causal relationship may be surprising to
some economists, but not to a businessman.
According to a businessman’s intuition, produc204

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tion would not rise until consumption demand
rises; and investment would not rise until profit
rises along with the rise in production. The key
elements missing in the businessman’s intuition,
however, are the aggregate resource constraint
and the price mechanism. Without changes in
production possibilities or prices, what would
enable consumption to rise in the first place without crowding out? General equilibrium business
cycle models embodying the resource constraint
and price mechanism, nevertheless, have trouble
conforming to the data. There must be something
fundamental missing in standard models, too. One
possible missing element is inventory investment.
Inventories provide a perfect buffer for consumpF E D E R A L R E S E R V E B A N K O F S T. LO U I S R E V I E W

Wen

tion when output cannot react immediately to
demand shocks. To model inventory behavior in
general equilibrium, however, is itself a challenge
and is therefore beyond the scope of this paper.13
My conjecture is that even with inventories introduced, the sequential information structure and
the source of shocks (aggregate demand) are still
crucial for the model to succeed. Hence, the
Granger causality concept and the empirical regularities documented in this paper can prove to
be a new litmus test for equilibrium business
cycle models.

REFERENCES
Baxter, Marianne and King, Robert G. “Productive
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Benhabib, Jess and Farmer, Roger E.A. “Indeterminacy
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Benhabib, Jess and Wen, Yi. “Indeterminacy,
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Granger, Clive W.J. “Investigating Causal Relations by
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Hansen, Gary D. “Indivisible Labor and the Business
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Wen, Yi. “Understanding the Inventory Cycle.”
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Burnside, Craig and Eichenbaum, Martin. “FactorHoarding and the Propagation of Business-Cycle
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For more recent work on this issue, see Kahn and Thomas (2004)
and Wen (2005a).

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