The full text on this page is automatically extracted from the file linked above and may contain errors and inconsistencies.
Centennial Issue
Federal Reserve Bank of St. Louis
P.O. Box 442
St. Louis, MO 63166-0442
Federal Reserve Bank of St. Louis
REVIEW
Centennial Issue
Nove mb e r / D e cemb er 2 0 1 3
Vo l u m e 95 , Nu m b e r 6
REVIEW
Commemorating the
Centennial of the Federal Reserve System
December 23, 1913–December 23, 2013
November/December 2013 • Volume 95, Number 6
REVIEW
Volume 95 • Number 6
President and CEO
James Bullard
Director of Research
Christopher J. Waller
A Special Issue of Review in Commemoration of
the Federal Reserve System Centennial
December 23, 1913–December 23, 2013
Policy Adviser
Cletus C. Coughlin
Deputy Director of Research
David C. Wheelock
Review Editor-in-Chief
449
Editor’s Introduction
William T. Gavin
William T. Gavin
Research Economists
David Andolfatto
Alejandro Badel
Subhayu Bandyopadhyay
Maria E. Canon
YiLi Chien
Silvio Contessi
Riccardo DiCecio
William Dupor
Carlos Garriga
Rubén Hernández-Murillo
Kevin L. Kliesen
Fernando M. Martin
Michael W. McCracken
Alexander Monge-Naranjo
Christopher J. Neely
Michael T. Owyang
B. Ravikumar
Juan M. Sánchez
Yongseok Shin
Daniel L. Thornton
Yi Wen
David Wiczer
Christian M. Zimmermann
Homer Jones: “Propensity, capacity, and opportunity”
Editor’s Comment
451
Homer Jones: A Personal Reminiscence
Milton Friedman
455
Confronting Monetary Policy Dilemmas:
The Legacy of Homer Jones
Beryl W. Sprinkel
461
The Credit Crisis and Cycle-Proof Regulation
Raghuram G. Rajan
Forces at Work: The Fed, Money, and Forward Guidance
Editor’s Comment
Managing Editor
George E. Fortier
Editors
Judith A. Ahlers
Lydia H. Johnson
469
Darryl Francis and the Making of Monetary Policy, 1966-1975
R. W. Hafer and David C. Wheelock
Graphic Designer
Donna M. Stiller
487
The Reform of October 1979: How It Happened and Why
David E. Lindsey, Athanasios Orphanides, and Robert H. Rasche
Federal Reserve Bank of St. Louis REVIEW
November/December 2013
i
543
Inflation Targeting in a St. Louis Model of the 21st Century
Robert G. King and Alexander L. Wolman
575
Announcements and the Role of Policy Guidance
Carl E. Walsh
Challenging Policy
Editor’s Comment
601
The GSEs: Where Do We Stand?
William Poole
613
Seven Faces of “The Peril”
James Bullard
629
Federal Reserve Bank of St. Louis Review
Annual Index, 2013
Review is published six times per year by the Research Division of the Federal Reserve Bank of St. Louis and may be accessed through our
website: research.stlouisfed.org/publications/review. All nonproprietary and nonconfidential data and programs for the articles written
by Federal Reserve Bank of St. Louis staff and published in Review also are available to our readers on this website. These data and programs
are also available through Inter-university Consortium for Political and Social Research (ICPSR) via their FTP site:
www.icpsr.umich.edu/pra/index.html. Or contact the ICPSR at P.O. Box 1248, Ann Arbor, MI 48106-1248; 734-647-5000;
netmail@icpsr.umich.edu.
The views expressed are those of the individual authors and do not necessarily reflect official positions of the Federal Reserve Bank of St. Louis,
the Federal Reserve System, or the Board of Governors.
Single-copy subscriptions (U.S. addresses only) are available free of charge: https://research.stlouisfed.org/publications/review/subscribe/.
General data can be obtained through FRED (Federal Reserve Economic Data), a database providing U.S. economic and financial data and
regional data for the Eighth Federal Reserve District. You may access FRED through our website: research.stlouisfed.org/fred.
Articles may be reprinted, reproduced, published, distributed, displayed, and transmitted in their entirety if copyright notice, author name(s),
and full citation are included. Please send a copy of any reprinted, published, or displayed materials to Research Division, Federal Reserve
Bank of St. Louis, P.O. Box 442, St. Louis, MO 63166-0442; STLS.Research.Publications@stls.frb.org. Please note: Abstracts, synopses, and
other derivative works may be made only with prior written permission of the Federal Reserve Bank of St. Louis. Please contact the Research
Division at the above address to request permission.
© 2013, Federal Reserve Bank of St. Louis.
ISSN 0014-9187
ii
November/December 2013
Federal Reserve Bank of St. Louis REVIEW
Homer Jones: “Propensity, capacity, and opportunity”
Homer Jones (1906-1986) was a professor and mentor of Milton Friedman at Rutgers University before joining
the Federal Reserve System, first the Board of Governors and later the St. Louis Fed. As director of research at
the St. Louis Fed from 1958 to 1971, Jones strongly promoted the collection of data and its use in economic
analysis. What was even more innovative and forward-thinking was his presentation and distribution of these
data—at first to policymakers and subsequently to the public. This effort placed the St. Louis Fed at the forefront of the regional Reserve Banks in contributing to national-level economic analysis, beyond the traditional
focus on their respective regional economies. St. Louis Fed leaders, including Jones, followed their research
wherever it led them and, in turn, challenged conventional wisdom and practices. This inclination to push the
boundaries of research and policymaking earned the Bank the label of “maverick in the Fed System,” as noted
in a Business Week article published November 18, 1967 (reprinted in the next section of this issue).
In 1976, Milton Friedman published a tribute to Homer Jones in the Journal of Monetary Economics; in it, he
described Jones’s abilities and inclinations, the state of policymaking at the time, and the role and impact of
the St. Louis Fed, where “propensity, capacity, and opportunity coalesced.” Friedman’s remarks capture a
remarkable period during which the St. Louis Fed contributed substantially to the discussion and implementation of monetary policy.
A noteworthy tribute to Jones’s leadership at the St. Louis Fed has been the Homer Jones Lecture Series, which
continues the tradition of serious, open discussion about the conduct of policy. Over the years, the invited
speakers have included renowned economists, financial analysts, and central bank policymakers worldwide.
The first lecture was delivered in March 1987 by Beryl M. Sprinkel, the chairman of the Council of Economic
Advisers at the time. His inaugural lecture, “Confronting Monetary Policy Dilemmas: The Legacy of Homer
Jones,” reminds policymakers that, among other things, policymakers must always be humble and consider
the possibility that their model may be flawed. Also included is the 2009 lecture delivered by Raghuram Rajan,
formerly the Eric J. Gleacher Distinguished Service Professor of Finance, University of Chicago Booth School of
Business, and now the governor of the Reserve Bank of India. In his lecture, “The Credit Crisis and Cycle-Proof
Regulation,” he reminds regulators of the need to design polices that will survive cycles of euphoria. During
good times, both the market and the regulators become overly confident, ignoring risk and relaxing credit limits. This leads to financial crisis and bad times, which cause regulators and loan officers to become overly cautious, adopting draconian measures to tighten credit limits.
The wide array of lectures over the years are compiled and available for reading on our website:
http://research.stlouisfed.org/conferences/homer/.
May 13, 1958, memo from St. Louis Fed president Delos C. Johns on the appointment of Homer Jones as
vice president and director of the Bank’s Research Department.
September 10, 1970, letter from Homer Jones to Arthur Burns, Chairman of the Board of Governors, on the
data reports provided by the St. Louis Fed.
An early issue of the St. Louis Fed’s data publication, U.S. Financial Data.
Top: L-R, Leonall Andersen, Dale Lewis, Darryl Francis, and Homer Jones.
Bottom: Darryl Francis and Homer Jones.
Centennial Issue
Homer Jones: A Personal Reminiscence
Milton Friedman
This article first appeared in the November 1976 issue of Journal of Monetary Economics.
Federal Reserve Bank of St. Louis Review, November/December 2013, 95(6), pp. 451-54.
hen I first met Homer Jones, he was a third older than I, a mature man of the world
in my eyes—though, as I now look back, I realize that he was only a callow youth
of 24, in his second year of teaching. Yet, in the nearly half century since, that original image has seemed to me to remain valid: In one sense, Homer matured early; in another
sense, Homer never matured.
I met Homer when I was a junior at Rutgers University, where he had just arrived as an
instructor, having gone from graduate work with Frank Knight at Chicago to teach at the
University of Pittsburgh for one year, and then on to Rutgers—if I recall rightly mainly in order
to coordinate better with the professional activity of his wife, Alice Hanson. As low man on the
academic totem pole, Homer was stuck with teaching, among other courses, insurance and statistics—two subjects that I doubt he had been exposed to before. At the time, I was planning to
become an actuary, so naturally I took both these subjects. Only later did I realize how fortunate
I was. Insurance would hardly seem a subject of far-ranging significance, yet Homer made it one.
His quizzical mind, his theoretical bent, yet withal his Iowa farmer interest in down-to-earth
practical matters, combined to lead us far beyond the dry, matter-of-fact textbook into the much
more fundamental issues of Risk, uncertainty, and profit.
In statistics, Homer was clearly learning along with us, and that experience has always persuaded me that the blind can in fact lead the blind—or is the right aphorism that in the country
of the blind, the one-eyed man is king. Because he was just learning, Homer could recognize the
points of difficulty. Because he was so mature despite his chronological youth, he had neither
false pride nor false modesty. He did not try to hide his limited knowledge of mathematics and
statistics, but neither was there any question, on his part or ours, that he was the teacher and we
the students.
W
At the time this article was written, the late Milton Friedman was a professor of economics at the University of Chicago.
This article has been reformatted since its original publication: Friedman, Milton. “Homer Jones: A Personal Reminiscence.” Journal of Monetary
Economics, November 1976, 2(4), pp. 433-36. Available at http://research.stlouisfed.org/conferences/homer/friedman.pdf.
Copyright © 1976, Elsevier. Used with permission. The views expressed in this article are those of the author(s) and do not necessarily reflect the
views of the Federal Reserve System, the Board of Governors, or the regional Federal Reserve Banks. 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.
Federal Reserve Bank of St. Louis REVIEW
November/December 2013
451
Friedman
The pattern of that course has characterized Homer ever since, with far less objective justification. Homer’s shrewd questions and critical evaluations belie the profession of ignorance and
puzzlement. But the tactic is extremely effective in leading others to examine more carefully their
premises, improve their argument, and understand more deeply their conclusions.
Chronological maturity, which can bring wisdom and self-confidence and, less often, modesty, also often brings a dulling of the inquisitive sense, of the feeling of wonder, of the openness
to new ideas that is the pearl of youth. It is in this sense that Homer has never matured. Today,
as when I first met him, Homer’s great forte is asking interesting and probing questions, not
accepting superficial answers, and retaining the attitude that we all have a great deal to learn. He
combines with this a great belief in the persuasive power of hard facts and an unusual patience
in pressing his views.
Homer’s inquisitiveness, his hunger for information and understanding, rested, even when
I first knew him, on a bedrock of strong values and firmly held principles. He first introduced
me to what was even then known as the Chicago view. A disciple of Frank Knight, and like him
a product of the rural Midwest, he put major stress on individual freedom, was cynical and skeptical about attempts to interfere with the exercise of individual freedom in the name of social
planning or collective values, yet was by no means a nihilist. It has always seemed to me a paradox
in Frank Knight, to a lesser extent in Homer—and I can believe that others say the same about
me—that they could be at once so cynical, realistic, and negative about the effects of reform
measures and yet at the same time be such ardent proponents of the “right” reform measures.
The paradox is perhaps brought out best by an episode in which Homer was not involved.
One evening in the early 1950s, a group of us were discussing various economic issues at Frank
Knight’s house, with much of the discussion consisting of Charles Hardy opposing one proposed
change after another. Finally, Frank Knight said, “Hardy, is there anything wrong in the world?”
Quick as a flash, Hardy retorted, “Yes, there are too damn many reformers.” How strange and
yet how correct that Knight should be labeled a “reformer.”
Homer, along with Arthur Burns, another of my teachers at Rutgers, was primarily responsible for my going on in economics—rather than in actuarial work or mathematics—both by opening my eyes to the broader reaches of economics and to the beauties and intricacies of economic
theory, and, on a more practical level, by getting me a scholarship to Chicago. Until that time,
I had never been west of the Delaware River—except perhaps to Philadelphia—and without
Homer’s advice and encouragement, it would never have occurred to me to take graduate work
in Chicago.
From Rutgers, Homer returned to graduate work at Chicago, then joined the New Deal
migration of economists to Washington, where, after a year at Brookings, he settled in for a
decade at the then recently established Federal Deposit Insurance Corporation [FDIC]. Before
our marriage, my wife worked for him as a research assistant for a time. Her fondest memory is
of Homer’s daily greeting—his “good morning” was always accompanied by either a nugget of
freshly acquired information or a question that had been nagging him, that he could not answer,
but always asked as if she obviously could. Also, the never-ending files—the reams of clippings
and other odds and ends that piqued Homer’s curiosity and that he wanted to squirrel away
because he was sure that they would sometime be useful.
452
November/December 2013
Federal Reserve Bank of St. Louis REVIEW
Centennial Issue
My own contacts with Homer were rather limited during this decade or the succeeding
decade when he was at the Board of Governors of the Federal Reserve System. We were personal
friends, part of the Chicago circle and more particularly the group that regarded themselves as
students of Frank Knight—including as key figures Lloyd Mints, Henry Simons, Aaron Director,
Russell Nichols, Allen Wallis, and George Stigler. Already in the early thirties, Homer had joined
with Allen, George, and me to edit The Ethics of Competition as an offering for Knight’s 50th
birthday. But beyond these personal and ideological connections, we had little professional
interaction. While Homer was at the FDIC, I was not working primarily in the monetary area.
After the war, when I was, and Homer was at the Federal Reserve Board, he came to be primarily responsible for the liquid assets survey, which the Fed conducted jointly with the Michigan
Survey Research Center.
Throughout this period most of Homer’s friends, and certainly my wife and I, believed that
his talents were being grossly underutilized—and that remains my opinion today. But finally in
1958 when by some strange chance he was called—and that is the proper word in this context—
to the Federal Reserve Bank of St. Louis, propensity, capacity, and opportunity coalesced.
Homer was in his element as Director of Research and then Senior Vice President of the
St. Louis Bank. He was at home again in the Midwest, in a bank that had always had a reputation
for independence and iconoclasm (I once teased William McChesney Martin Jr. at a Federal
Reserve meeting by referring to some critical remarks that his father had made at an open market
meeting in 1930 or so when his father was Governor of the St. Louis Bank, remarking, “You see,
Bill, St. Louis was a maverick even then”), and with a President, Darryl Francis, who shared his
basic values, as well as his integrity and independence of character, and had a properly high regard
for his abilities.
Between them, Homer and Darryl Francis converted the St. Louis Bank into by far the most
important unit in the System. For the first time since the days of Walter Stewart, Winfield Riefler,
and Randolph Burgess in the 1920s, monetary research from within the System began to influence academic research and thinking. For the first time, a bank publication, The Review of the
Federal Reserve Bank of St. Louis, began to be citied regularly in the academic journals. This
academic revival was joined with a similar penetration into practical affairs. Homer’s insatiable
curiosity about the facts, and his belief in the power of repeated exposure to the facts to erode
illusion, led to the publication by the Bank of its now famed series of weekly and monthly collections of statistics. These preached no explicit doctrine. They simply presented numbers. Yet the
appearance week after week of those clearly drawn charts of the money supply did more than
any other single thing, in my opinion, to bring about the change that has occurred from almost
exclusive concentration in monetary policy on interest rates and on the esoteric “tone and feel
of the market” to stress on the quantity of money. The shift is not yet complete but without Homer,
I doubt that it would have occurred to anything like the extent it has.
Homer’s influence is not to be looked for primarily or even largely in publications over his
name. His influence is manifest rather in the whole output of the Federal Reserve Bank of St. Louis,
from its great contribution to the improvement of current monetary statistics, to the series of
important and wide-ranging articles in its Review, to the speeches of its senior officials, to the
positions taken at the Open Market Committee and before Congress by its President. It is to be
Federal Reserve Bank of St. Louis REVIEW
November/December 2013
453
Friedman
found also in the people whom Homer searched out, attracted to St. Louis, taught and influenced,
and who are now spread far and wide. The hallmark of his contribution is throughout those
same traits that exerted so great an influence on me in my teens: complete intellectual honesty;
insistence on rigor of analysis; concern with facts; a drive for practical relevance; and, finally,
perpetual questioning and reexamination of conventional wisdom. ■
454
November/December 2013
Federal Reserve Bank of St. Louis REVIEW
Centennial Issue
Confronting Monetary Policy Dilemmas:
The Legacy of Homer Jones
Beryl W. Sprinkel
This article first appeared in the March 1987 issue of Review.
Federal Reserve Bank of St. Louis Review, November/December 2013, 95(6), pp. 455-60.
t is an honor to deliver this first annual lecture in memory of Homer Jones. I first became
acquainted with Homer when writing my thesis at the University of Chicago, and I found
some of his writings to be particularly useful. When Homer later became Director of
Research at the St. Louis Federal Reserve Bank, it was—like many things in life—not particularly
momentous in itself, but the implications for monetaiy economics were certainly important.
In his priceless style, Harry Johnson described Homer Jones as “…an oasis in the desert that
Keynesian economics and concern with credit had made of the Federal Reserve System, [and]
the last outpost of classical monetary civilization in a cancerous culture of barbarian bumptiousness.” Only an academic, of course, could say something like that—and about an era that fortunately has long passed at the Federal Reserve.
Homer Jones should be remembered for many things, not the least of which is the many
people whose intellectual development he shaped and whose professional lives he fostered. He
was one of Milton Friedman’s first teachers—not in economics, but in insurance and statistics.
Milton credits him for providing the inspiration that sparked his initial interest in economics, as
well as something more tangible—getting him a scholarship to attend the University of Chicago.
And, of course, Homer had a strong influence on the professional lives of the many economists
who worked for him in his years at the St. Louis Fed.
Homer had an intense respect for the market system; that permeated both his economic
analysis and his views about economic policy. His basic policy prescriptions in macroeconomics
I
At the time this article was written, Beryl W. Sprinkel was the chairman of the Council of Economic Advisers. His speech, given on March 26, 1987,
at Washington University in St. Louis, is the first annual Homer Jones Memorial Lecture, which was co-sponsored by the Federal Reserve Bank of
St. Louis, the Center for the Study of American Business at Washington University, and the St. Louis chapter of the National Association of Business
Economists.
This article has been reformatted since its original publication in Review: Sprinkel, Beryl W. “Confronting Monetary Policy Dilemmas: The Legacy
of Homer Jones.” Federal Reserve Bank of St. Louis Review, March 1987, pp. 5-8;
http://research.stlouisfed.org/publications/review/87/03/Confronting_Mar1987.pdf.
© 2013, The Federal Reserve Bank of St. Louis. The views expressed in this article are those of the author(s) and do not necessarily reflect the views
of the Federal Reserve System, the Board of Governors, or the regional Federal Reserve Banks. 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.
Federal Reserve Bank of St. Louis REVIEW
November/December 2013
455
Sprinkel
reflected this free market orientation: a distrust of the efficacy of fine-tuning and a fundamental
belief in the inherent stability of a free market economy. His reliance on the market approach to
problems also extended to international issues, labor market issues, and regulatory policy. From
my perspective, the extent to which such principles have become more generally accepted as a
basis for public policy decisions is remarkable, not only in the United States, but in other countries as well. Both as an Undersecretary at Treasury and as CEA [Council of Economic Advisers]
Chairman, I have been involved, along with officials from other governments, in policy discussions on issues ranging from agriculture to tax reform. In governments around the world, there
is a greater recognition of the efficiency of the market system in pricing goods and allocating
resources. While much progress can still be made toward improving public policy analysis and
discussion, the movement toward greater reliance on market forces is one I applaud, as I am sure
Homer would as well.
One particular area where we have made substantial progress by relying on market forces is
in the deregulation of financial markets and institutions. Regulations on interest rates paid by
financial institutions to their depositors have been eliminated. Restrictions on competition within
classes of financial institutions and between different classes have been reduced. In this area,
however, more needs to be accomplished, and I suspect that Homer would share my desire to
see rapid progress on the administration’s proposals for further financial market deregulation.
It was difficult to be around Homer without learning a great deal from him. He had a remarkable ability to focus on the practical issues and an impatience with intellectual pretense and
academic irrelevancy. His technique was to put questions to you—always pertinent questions,
frequently penetrating questions, sometimes relentless questions. In so doing, he forced you to
understand and articulate what you knew, while discovering what you did not know. He had a
truly unusual ability to stimulate you to search for the answers. In the St. Louis Fed Research
Department, I am sure that many promising ideas were hatched, many empirical relations were
tested, and many influential articles resulted directly from Homer’s inquiring mind and his ability to transmit that interest to others.
The products of Homer Jones’s style and approach at the St. Louis Fed are well known and
well respected. The weekly and monthly publications of the Research Department, which have
now become standard references for everyone from undergraduates to White House officials,
were initially Homer’s products. The St. Louis Fed Research Department became one of the most
prominent in the country and its monthly Review became widely respected and earned the stature
of a professional journal. The metamorphosis of the Research Department, its role in promoting
policy-related research and in providing an alternative point of view within the System was what
Karl Brunner has labeled “a remarkable institutional event,” made more remarkable and more
influential because it occurred within the System itself.
Given the nature of Homer Jones’s legacy, it is ironic—and perhaps fitting—that we are gathered here to honor his contributions at a time when there are so many unanswered questions
about the conduct of monetary policy. The policy issues we face today are different from those
debated by Homer. Most analysts now accept the important role of monetary policy in economic
performance. Most economists acknowledge an important relation between changes in money
growth and economic activity, although in recent years there has been much more uncertainty
456
November/December 2013
Federal Reserve Bank of St. Louis REVIEW
Centennial Issue
about the precise form of that once-reliable relationship. Few doubt, at least in general terms,
the long-run link between money growth and inflation. Rather than those fundamental issues
that we debated in the 1950s and 1960s, the policy challenges of today relate to the changed
environment in which monetary policy is now conducted.
In the four years since this expansion began, there have been substantial changes in both
the institutional and economic environment in which monetary policy must be designed and
implemented. These developments are well known to this audience. The inflation rate—excluding
the effects of the oil price declines in 1988—has been cut to one-third the 1980 rate. Similarly,
interest rates are one-third to one-half their 1980 levels. Financial deregulation has changed the
institutional structure in which monetary policy is conducted. In this decade, the introduction
of NOW [negotiable orders of withdrawal] and money market accounts has significantly altered
the composition of the monetary aggregates, and the relaxation of restrictions on deposit interest
rates has led to the inclusion in M1 of interest-bearing deposits which pay market-determined
rates of return.
These developments—and possibly others—appear to be affecting the basic relation between
money and nominal GNP [gross national product] growth as indicated by the behavior of the
“velocity” of money. Specifically, while there have always been sizable fluctuations in velocity
from one quarter to the next, over longer periods velocity rose at a reasonably predictable rate
of about 3 percent per year between 1947 and 1981. Since the cyclical peak of 1981, however,
velocity has declined at more than a 3 percent annual rate.
There are a number of plausible explanations for this decline in velocity. However, with the
limited data available, it is difficult to reach definitive conclusions.
To my knowledge, the most promising lines of empirical research attempt to relate velocity
declines to the decline in inflation and interest rates and to their effect on the interest-elasticity
of the demand for money. In the recent period of declining interest rates, the opportunity cost
of holding the highly liquid balances in M1 has fallen, thereby raising desired M1 balances and
suppressing velocity. As market interest rates change, the public response in terms of moving in
and out of Ml balances is difficult to predict. In part this is because we have relatively little experience with deregulated deposit rates and also because it is not clear how depository institutions
will adjust deposit rates to changes in market rates. This implies continued uncertainty about
the future behavior of velocity.
Over most of this expansion we have had monetary growth—particularly in M1—that, based
on the historical relation with nominal spending and inflation, would be viewed as excessive.
Yet, we have not had the short-run surge in real growth and nominal spending that would be
expected from such high M1 growth. We are therefore left with a difficult dilemma about the
implications of recent M1 growth for future inflation. On that issue, a wide range of opinion
exists. Some forecasters—many of whom are long-time friends of mine—foresee a major resurgence of inflation resulting from the monetary growth of the past two years. Other analysts discount recent M1 growth as being the result of financial deregulation, disinflation, declining
interest rates, or some combination of such factors.
It is interesting to note, however, that even those who rely most heavily on money growth
as a forecasting tool are not predicting an inflation as high as would be implied by historical
Federal Reserve Bank of St. Louis REVIEW
November/December 2013
457
Sprinkel
velocity behavior. The Shadow Open Market Committee, for example, forecasts inflation and
nominal GNP growth consistent with the assumption that velocity growth remains well below its
postwar trend growth path. Neither the most recent Blue Chip forecasts nor the administration’s
economic projections reflect the expectation that recent M1 growth will be translated into spending and inflation in accordance with historical velocity behavior. In fact, I know of no serious,
current forecast that does not implicitly assume continued atypical velocity behavior, at least
over the coming year.
These and related questions have made the conduct of monetary policy particularly difficult
over the course of this expansion. It is my judgment that in the context of considerable uncertainty about velocity growth, the Federal Reserve has done a reasonably good job balancing the
risk of renewed inflation against the risks associated with too little money growth. I do not believe,
however, that we can afford to be complacent about a long continuation of the money growth
we have experienced in recent years. The Reagan administration is committed not just to reducing inflation, but to the ultimate goal of restoring price stability. By distorting price signals and
eroding productive incentives, inflation is a powerful deterrent to long-term real growth and
job creation. Moreover, high inflation ultimately brings the high costs of reducing the inflation
rate—costs that our economy paid in the recession of 1981-82 and that are still being paid in
such sectors of our economy as agriculture and energy. Given the inevitable costs associated
with reducing inflation and the importance to long-term prosperity of keeping inflation under
control, it would be a policy blunder to allow inflation to reaccelerate.
In assessing monetary policy, it is important to recognize what it can and cannot accomplish.
It cannot smooth out all short-term fluctuations in output, employment, or the price level. Nor
can it sustain real growth rates that consistently exceed the economy’s potential—as determined
by underlying rates of productivity and population growth and trends in labor force participation. Monetary policy, however, can deliver reasonable stability of the price level in the longer
run and can avoid being an additional important cause of disturbances to output and employment growth in the shorter run.
Monetary policy has contributed to the success we have enjoyed in resolving the critical
problems that confronted the U.S. economy when President Reagan assumed office. The annual
inflation rate has been cut by two-thirds—from double-digit levels in 1979-80 to about 4 percent
for the past four years. Interest rates generally have fallen to about one-third of the levels of six
years ago.The economy is now in the 52nd month of what will soon become the longest peacetime expansion since World War II. As this expansion has proceeded, in contrast with the experience in earlier expansions, the inflation rate and interest rates have shown no tendency to rise
and to bring about the strains that led to the ends of earlier expansions. Thus, the destructive
sequence of business cycles with progressively rising inflation and interest rates has been broken,
and the foundation has been laid for sustainable real growth with moderate inflation.
The problems that remain in the U.S. economy are not primarily problems that can be
addressed with monetary policy—beyond its normal role in gradually moving toward the goal
of long-run price stability, while avoiding being a source of macroeconomic disturbance. In
particular, the critical and related problems of the large federal deficit and of the large U.S. trade
deficit cannot be resolved by monetary policy.
458
November/December 2013
Federal Reserve Bank of St. Louis REVIEW
Centennial Issue
The federal government has a deficit because the share of federal spending in GNP has risen
well above the average share that federal revenue has maintained in GNP for three decades. The
solution is to restrain the absolute growth of federal spending, while economic growth raises
the absolute level of federal revenues.
The United States has a trade deficit because we as a nation spend more than the value of
what we produce. To finance this excessive spending, we import capital from the rest of the world
in an amount that corresponds to our current account deficit. Excessive federal spending and
corresponding federal borrowing are an important part of the problem—and reversing them is
an important part of the solution. So too are stronger, internally generated growth and more
open trade policies on the part of our trading partners. We require a coordinated approach to
reducing international payments imbalances in an environment that maintains world economic
growth.
I could discuss further the problems of our fiscal and trade deficits, as well as other problems
of the U.S. economy. However, my experience even before I went to Washington taught me
brevity is a virtue—perhaps a virtue even more appreciated by audiences than by speakers.
Among the things that I have learned in Washington—and there are many—one of the most
important is how simple things look from the outside, but how much more difficult it is when
you actually have to take action and assume the responsibility for its effect on people’s well-being.
In policymaking, things are seldom simple. Certainly in the macroeconomic field, where policy
tools are blunt and forecasts are frequently wrong, there are risks associated with any policy
decision. Ultimately, policymakers must face the question: What are the consequences if I am
wrong? If nothing else, it is a humbling experience.
No one in my memory had learned this lesson better than Homer Jones. His humble and
unpretentious personal style was reflected in his professional approach: Take nothing for granted
and believe only what can be justified by the data. So what would Homer have to say about the
current dilemma? I like to tell my staff—some of them think I tell them too often—that I’m from
the “Show-Me” State. I want to see the data to support a conclusion. While Homer wasn’t born
in Missouri as I was, he certainly adopted the show-me attitude about economic issues. Knowing
his insistence that policy be based on empirically tested relations, he surely would share the
concerns about high money growth over the past few years. He surely would not easily discard
long-term empirical relationships. But I also doubt that he would counsel ignoring current
developments as they have varied dramatically from historical patterns.
Given the aberrant behavior of velocity over the past four years or so, policymakers have
little alternative but to supplement the information provided by the monetary aggregates with
other relevant data. To me, this implies looking in addition at interest rates, exchange rates,
sensitive prices such as gold and other commodities, forward markets, and measures of real
economic activity for signals as to the meaning and implication of money growth and monetary
policy actions. The limitations and deficiencies of these data as guides to monetary policy are
great and are well known, and I will not recount them here. It is not an ideal approach, but I see
no workable alternative at the present time. To date, I know of no completely satisfactory explanation of what has happened to velocity. When more time has passed in a deregulated and lowinflation environment, I am confident that reliable relationships will re-emerge, which I trust
Federal Reserve Bank of St. Louis REVIEW
November/December 2013
459
Sprinkel
can be identified by appropriate empirical testing. In the interim, policy decisions must be made
that properly balance the risks to the economy of alternatively too much or too little money
growth. As a nation, we cannot afford the pain and disruption of allowing inflation to resurge,
nor can we afford to risk the economic consequences of excessive monetary restriction.
In a sense, the dilemmas and frustrations of today’s policy issues lead those of us who knew
Homer Jones to plead, “Homer, where are you when we need you?” For today, we surely could
use his quiet, reasoned assessment of the issues.
Many people accomplish important things in their lives. I wonder whether there are not
more important things to be remembered for than what you invented, discovered, wrote, or
built. It may be a more-lasting legacy to be remembered for how you influenced the thinking
and accomplishments of others. Among those of us who call ourselves monetary economists,
few can claim that legacy as readily as Homer Jones. ■
460
November/December 2013
Federal Reserve Bank of St. Louis REVIEW
Centennial Issue
The Credit Crisis and Cycle-Proof Regulation
Raghuram G. Rajan
This article was originally presented as the Homer Jones Memorial Lecture, organized by the Federal
Reserve Bank of St. Louis, St. Louis, Missouri, April 15, 2009.
This article first appeared in the September/October 2009 issue of Review.
Federal Reserve Bank of St. Louis Review, November/December 2013, 95(6), pp. 461-67.
irst, I would like to thank the St. Louis Fed, especially Kevin Kliesen, and the National
Association for Business Economics for inviting me to give this talk. I share with Homer
Jones an affiliation with the University of Chicago. He was an important influence on
Milton Friedman, and if that were all he did, he would deserve a place in history. But in addition, he was a very inquisitive economist with a reputation for thinking outside the box. He
made major contributions to monetary economics. It is an honor to be asked to deliver a lecture
in his name, especially at this critical time in the nation’s regulatory history.
F
WHAT CAUSED THE CRISIS?
The current financial crisis can be blamed on many factors and even some particular players
in financial markets and regulatory institutions. But in pinning the disaster on specific agents,
we could miss the cause that links them all. I argue that this common cause is cyclical euphoria;
and, unless we recognize this, our regulatory efforts are likely to fall far short of preventing the
next crisis.
Let me start at the beginning. There is some consensus that the proximate causes of the crisis
are as follows: (i) The U.S. financial sector misallocated resources to real estate, financed through
the issuance of exotic new financial instruments. (ii) A significant portion of these instruments
found their way, directly or indirectly, onto commercial and investment bank balance sheets.
At the time this article was written, Raghuram G. Rajan was the Eric Gleacher Distinguished Service Professor of Finance at the Booth School of
Business, University of Chicago.
This article has been reformatted since its original publication in Review: Rajan, Raghuram G. “The Credit Crisis and Cycle-Proof Regulation.”
Federal Reserve Bank of St. Louis Review, September/October 2009, 91(5, Part 1), pp. 397-402;
http://research.stlouisfed.org/publications/review/09/09/part1/Rajan.pdf.
© 2013, The Federal Reserve Bank of St. Louis. The views expressed in this article are those of the author(s) and do not necessarily reflect the views
of the Federal Reserve System, the Board of Governors, or the regional Federal Reserve Banks. 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.
Federal Reserve Bank of St. Louis REVIEW
November/December 2013
461
Rajan
(iii) These investments were financed largely with short-term debt. (iv) The mix was potent and
caused large-scale disruption in 2007. On these matters, there is broad agreement. But let us dig
a little deeper.
This is a crisis born in some ways from previous financial crises. A wave of crises swept
through the emerging markets in the late 1990s: East Asian economies collapsed, Russia defaulted,
and Argentina, Brazil, and Turkey faced severe stress. In response to these problems, emerging
markets became far more circumspect about borrowing from abroad to finance domestic demand.
Instead, their corporations, governments, and households cut back on investment and reduced
consumption. Formerly net absorbers of financial capital from the rest of the world, a number of
these countries became net exporters of financial capital. Combined with the savings of habitual
exporters such as Germany and Japan, these circumstances created what Chairman Bernanke
referred to as a “global saving glut” (Bernanke, 2005).
Clearly, the net financial savings generated in one part of the world must be absorbed by
deficits elsewhere. Corporations in industrialized countries initially absorbed these savings by
expanding investment, especially in information technology, but this proved unsustainable and
investment was cut back sharply after the collapse of the information technology bubble.
Extremely accommodative monetary policy by the world’s central banks, led by the Federal
Reserve, ensured the world did not suffer a deep recession. Instead, the low interest rates in a
number of countries ignited demand in interest-sensitive sectors such as automobiles and housing. House prices started rising, as did housing investment.
U.S. price growth was by no means the highest. Housing prices reached higher values relative
to rent or incomes in Ireland, Spain, the Netherlands, the United Kingdom, and New Zealand,
for example. Then why did the crisis first manifest itself in the United States? Probably because
the United States went further with financial innovation, thus drawing more buyers with marginal credit quality into the market.
Holding a home mortgage loan directly is very hard for an international investor because it
requires servicing, is of uncertain credit quality, and has a high propensity for default. Securitization dealt with some of these concerns. If the mortgage was packaged together with mortgages
from other areas, diversification would reduce the risk. Furthermore, the riskiest claims against
the package could be sold to those with the capacity to evaluate them and an appetite for bearing
the risk, while the safest AAA-rated portions could be held by international investors.
Indeed, because of the demand from international investors for AAA paper, securitization
focused on squeezing out the most AAA paper from an underlying package of mortgages: The
lower-quality securities issued against the initial package of mortgages were repackaged once
again with similar securities from other packages, and a new range of securities, including a large
quantity rated AAA, was issued by this “collateralized debt obligation.”
The “originate-to-securitize” process had the unintended consequence of reducing the due
diligence undertaken by originators. Of course, originators could not completely ignore the true
quality of borrowers because they were held responsible for initial defaults, but because house
prices were rising steadily over this period, even this source of discipline weakened.
If the buyer could not make even the nominal payments involved on the initial low mortgage
teaser rates, the lender could repossess the house, sell it quickly in the hot market, and recoup
462
November/December 2013
Federal Reserve Bank of St. Louis REVIEW
Centennial Issue
any losses through the price appreciation. In the liquid housing market, as long as the buyer could
scrawl an “X” on the dotted line, he or she could own a home.
The slicing and dicing through repeated securitization of the original package of mortgages
created very complicated securities. The problems in valuing these securities were not obvious
when house prices were rising and defaults were few. But as house prices stopped rising and
defaults started increasing, the valuation of these securities became very complicated.
MALEVOLENT BANKERS OR FOOLISH NAÏFS?
It was not entirely surprising that bad investments would be made in the housing boom.
What was surprising was that the originators of these complex securities—the financial institutions that should have understood the deterioration of the underlying quality of mortgages—held
on to so many of the mortgage-backed securities (MBS) in their own portfolios. Simply: Why
did the sausage-makers, who knew what was in the sausage, keep so many sausages for personal
consumption?
The explanation has to be that at least one arm of the bank thought these securities were
worthwhile investments, despite their risk. Investment in MBS seemed to be part of a culture of
excessive risk-taking that had overtaken banks. A key factor contributing to this culture is that,
over short periods of time, it is very hard, especially in the case of new products, to tell whether
a financial manager is generating true excess returns adjusting for risk or whether the current
returns are simply compensation for a risk that has not yet shown itself but will eventually materialize. Such difficulty could engender excess risk-taking both at the top of and within the firm.
For instance, the performance of CEOs is evaluated in part on the basis of the earnings they
generate relative to their peers. To the extent that some leading banks can generate legitimately
high returns, this puts pressure on other banks to keep up. CEOs of “follower” banks may take
excessive risks to boost various observable measures of performance.
Indeed, even if managers recognize that this type of strategy is not truly value creating, a
desire to pump up their bank’s stock prices and their own reputations may nevertheless make it
their most attractive option. There is anecdotal evidence of such pressure on top management—
perhaps most famously from Citigroup chairman, Chuck Prince, in describing why his bank
continued financing buyouts despite mounting risks: “When the music stops, in terms of liquidity, things will be complicated. But, as long as the music is playing, you’ve got to get up and dance.
We’re still dancing” (Wighton, 2007).
Even if top management wants to maximize long-term bank value, it may be difficult to
create incentives and control systems that steer subordinates in this direction. Given the competition for talent, traders have to be paid generously based on performance, but many of the
compensation schemes paid for short-term, risk-adjusted performance. This setting gave traders
an incentive to take risks that were not recognized by the system, so they could generate income
that appeared to stem from their superior abilities, even though it was in fact only a market-risk
premium.
The classic case of such behavior is to write insurance on infrequent events such as defaults,
assuming what is termed “tail” risk. If traders are allowed to boost bonuses by treating the entire
Federal Reserve Bank of St. Louis REVIEW
November/December 2013
463
Rajan
insurance premium as income, instead of setting aside a significant fraction as a reserve for an
eventual payout, they have an excessive incentive to engage in this sort of trade.
Indeed, traders who bought AAA-rated MBS were essentially getting the additional spread
on these instruments relative to corporate AAA securities (the spread being the insurance premium) while ignoring the additional default risk entailed in these untested securities. The traders
in AIG’s financial products division took all this to an extreme by writing credit default swaps,
pocketing the premiums as bonuses, and not bothering to set aside reserves in case the bonds
covered by the swaps actually defaulted.
This is not to say that risk managers in banks were unaware of such incentives. However,
they may have been unable to fully control them, because tail risks are by their nature rare and
therefore hard to quantify with precision before they occur. Although the managers could try to
impose crude limits on the activities of the traders taking maximum risk, these types of trades
were likely to have been very profitable (before the risk actually was realized) and any limitations
on such profits are unlikely to sit well with a top management that is being pressured for profits.
Finally, all these shaky assets were financed with short-term debt. Why? Because in good
times, short-term debt seems relatively cheap compared with long-term capital, and the market
is willing to supply it because the costs of illiquidity appear remote. Markets seem to favor a bank
capital structure that is heavy on short-term leverage. In bad times, though, the costs of illiquidity
seem to be more salient, while risk-averse (and burnt) bankers are unlikely to take on excessive
risk. The markets then encourage a capital structure that is heavy on capital. Given the conditions
that led banks to hold large quantities of MBS and other risky loans (such as those to private
equity financed with a capital structure heavy on short-term debt), the crisis had a certain degree
of inevitability.
As house prices stopped rising, and indeed started falling, mortgage defaults started increasing. MBS fell in value and became more difficult to price, and their prices became more volatile.
They became hard to borrow against, even over the short term. Banks became illiquid and eventually insolvent. Only heavy intervention has kept the financial system afloat, and though the
market seems to believe that the worst is over, its relief may be premature.
The Blame Game
Who is to blame for the financial crisis? As my discussion suggests, there are many possible
suspects—the exporting countries that still do not understand that their thrift is a burden and
not a blessing to the rest of the world; the U.S. households that have spent way beyond their means
in recent years; the monetary and fiscal authorities who were excessively ready to intervene to
prevent short-term pain, even though they only postponed problems into the future; the bankers
who took the upside and left the downside to the taxpayer; the politicians who tried to expand
their vote banks by extending homeownership to even those who could not afford it; the markets
that tolerated high leverage in the boom only to become risk averse in the bust…The list goes on.
There are plenty of suspects and enough blame to spread. But if all are to blame, should we
also not admit they all had a willing accomplice—the euphoria generated by the boom? After
all, who is there to stand for stability and against the prosperity and growth in a boom?
464
November/December 2013
Federal Reserve Bank of St. Louis REVIEW
Centennial Issue
Internal risk managers, who repeatedly pointed to risks that never materialized during an
upswing, have little credibility and influence—that is, if they still have jobs. It is also very hard
for contrarian investors to bet against the boom: As Keynes said, the market can stay irrational
longer than investors can stay solvent. Politicians have an incentive to ride the boom, indeed to
abet it, through the deregulation sought by bankers. After all, bankers have not only the money
to influence legislation but also the moral authority conferred by prosperity.
And what of regulators? When everyone is “for” the boom, how can regulators stand against
it? They are reduced to rationalizing why it would be technically impossible for them to stop it.
Everyone is therefore complicit in the crisis because, ultimately, they are aided and abetted
by cyclical euphoria. And unless we recognize this, the next crisis will be hard to prevent. For
we typically regulate in the midst of a bust when righteous politicians feel the need to do something, when bankers’ frail balance sheets and vivid memories make them eschew any risk, and
when regulators’ backbones are stiffened by public disapproval of past laxity.
THE ROLE OF REGULATION
We reform under the delusion that the regulated—and the markets they operate in—are
static and passive and that the regulatory environment will not vary with the cycle. Ironically,
faith in draconian regulation is strongest at the bottom of the cycle—when there is little need
for participants to be regulated. By contrast, the misconception that markets will take care of
themselves is most widespread at the top of the cycle—the point of maximum danger to the system. We need to acknowledge these differences and enact cycle-proof regulation, for a regulation
set against the cycle will not stand.
Consider the dangers of ignoring this point. Recent studies such as the Geneva Report
(Brunnermeier et al., 2009) have argued for “countercyclical” capital requirements—raising bank
capital requirements significantly in good times, while allowing them to fall somewhat in bad
times. Although this approach is sensible prima facie, these proposals may be far less effective
than intended.
To see why this is so, we need to recognize that in boom times, the market demands very
low levels of capital from financial intermediaries, in part because euphoria makes losses seem
remote. So when regulated financial intermediaries are forced to hold more costly capital than
the market requires, they have an incentive to shift activity to unregulated intermediaries, as
did banks in setting up structured investment vehicles and conduits during the current crisis.
Changes in Regulation
Even if regulations are strengthened to detect and prevent this shift in activity, banks can
subvert capital requirements by assuming risk the regulators do not see or do not penalize adequately with capital requirements. Attempts to reduce capital requirements in busts are equally
fraught. The risk-averse market wants banks to hold much more capital than regulators require,
and its will naturally prevails. Even the requirements themselves may not be immune to the cycle.
Once memories of the current crisis fade and the ideological cycle turns, the political pressure
to soften capital requirements or their enforcement will be enormous.
Federal Reserve Bank of St. Louis REVIEW
November/December 2013
465
Rajan
To have a better chance of creating stability through the cycle—of being cycle-proof—new
regulations should be comprehensive, contingent, and cost effective. Regulations that apply comprehensively to all levered financial institutions are less likely to encourage the drift of activities
from heavily regulated to lightly regulated institutions over the boom, a source of instability
because the damaging consequences of such drift come back to hit the heavily regulated institutions during the bust through channels no one foresees.
Regulations should also be contingent so they have maximum force when the private sector
is most likely to do itself harm but bind less the rest of the time. This will make regulations more
cost-effective, which also makes them less prone to arbitrage or dilution.
Consider some examples of such regulations. First, instead of asking institutions to raise
permanent capital, ask them to arrange for capital to be infused when the institution or the system
is in trouble. Because these “contingent capital” arrangements will be contracted in good times
(when the chances of a downturn seem remote), they will be relatively cheap (compared with
raising new capital in the midst of a recession) and thus easier to enforce. Also, because the infusion is seen as an unlikely possibility, firms cannot go out and increase their risks by using the
future capital as backing. Finally, because the infusions occur in bad times when capital is really
needed, they protect the system and the taxpayer in the right contingencies.
One version of contingent capital is requiring banks to issue debt that would automatically
convert to equity when two conditions are met: first, when the system is in crisis, either based
on an assessment by regulators or based on objective indicators; and second, when the bank’s
capital ratio falls below a certain value (Squam Lake Working Group on Financial Regulation,
2009). The first condition ensures that banks that do badly because of their own idiosyncratic
errors, and not when the system is in trouble, do not avoid the disciplinary effects of debt. The
second condition rewards well-capitalized banks by allowing them to avoid the forced conversion (the number of shares to which the debt converts will be set at a level to substantially dilute
the value of old equity), while also giving banks that anticipate losses an incentive to raise new
equity well in advance.
Another version of contingent capital is requiring systemically important levered financial
institutions to buy fully collateralized insurance policies (from unlevered institutions, foreigners,
or the government) that will infuse capital into these institutions when the system is in trouble
(Kashyap, Rajan, and Stein, 2009).
Here is one way this type of system could operate. Megabank would issue capital insurance
bonds—say, to sovereign wealth funds—and invest the proceeds in Treasury bonds, which would
then be placed in a custodial account in State Street Bank. Every quarter, Megabank would pay
a pre-agreed insurance premium (contracted at the time the capital insurance bond is issued)
which, together with the interest accumulated on the Treasury bonds held in the custodial account,
would be paid to the sovereign fund.
If the aggregate losses of the banking system exceed a certain prespecified amount, Megabank
would start receiving a payout from the custodial account to bolster its capital. The sovereign
wealth fund would then face losses on the principal it has invested, but on average, it would be
compensated by the insurance premium.
466
November/December 2013
Federal Reserve Bank of St. Louis REVIEW
Centennial Issue
Consider regulations aimed at “too big to fail” institutions. Regulations to limit their size
and activities will become very onerous when growth is high, thus increasing the incentive to
dilute these regulations. Perhaps, instead, a more cyclically sustainable regulation would be to
make these institutions easier to close down. What if systemically important financial institutions were required to develop a plan that would enable them to be resolved over a weekend?
Such a “shelf bankruptcy” plan would require banks to track, and document, their exposures
much more carefully and in a timely manner, probably through much better use of technology.
The plan would require periodic stress testing by regulators and the support of enabling legislation—such as facilitating an orderly transfer of a troubled institution’s swap books to precommitted
partners. Not only would the requirement to develop resolution plans give these institutions the
incentive to reduce unnecessary complexity and improve management, it also would not be much
more onerous in the boom cycle and might indeed force management to think the unthinkable
at such times.
CONCLUSION
A crisis offers us a rare window of opportunity to implement reforms—it is a terrible thing
to waste. The temptation will be to overregulate, as we have done in the past. This creates its
own perverse dynamic. For as we start eliminating senseless regulations once the recovery takes
hold, we will find deregulation adds so much economic value that it further empowers the
deregulatory camp. Eventually, though, the deregulatory momentum will cause us to eliminate
regulatory muscle rather than fat. Perhaps rather than swinging maniacally between too much
and too little regulation, it would be better to think of cycle-proof regulation. ■
REFERENCES
Bernanke, Ben S. “The Global Saving Glut and the U.S. Current Account Deficit.” Remarks by Governor Ben S. Bernanke
at the Homer Jones Memorial Lecture, St. Louis, Missouri, April 14, 2005;
http://www.federalreserve.gov/boarddocs/speeches/2005/ 20050414/default.htm.
Brunnermeier, Markus K.; Crockett, Andrew; Goodhart, Charles A.; Persaud, Avinash D. and Shin, Hyun Song. The
Fundamental Principles of Financial Regulation: Geneva Reports on the World Economy 11. London: Centre for
Economic Policy Research, 2009.
Kashyap, Anik K.; Rajan, Raghuram G. and Stein, Jeremy C. “Rethinking Capital Regulation” in Federal Reserve Bank of
Kansas City Symposium, Maintaining Stability in a Changing Financial System, February 2009, pp. 431-71;
http://www.kc.frb.org/publicat/sympos/2008/KashyapRajanStein.03.12.09.pdf.
Squam Lake Working Group on Financial Regulation. “An Expedited Resolution Mechanism for Distressed Financial
Firms: Regulatory Hybrid Securities.” Working paper, Council on Foreign Relations, Center for Geoeconomic Studies;
April 2009; http://www.cfr.org/content/publications/attachments/Squam_Lake_Working_Paper3.pdf.
Wighton, David. “Citigroup Chief Stays Bullish on Buy-Outs.” Financial Times, July 9, 2007;
http://www.ft.com/cms/s/0/80e2987a-2e50-11dc-821c-0000779fd2ac.html?nclick_check=1.
Federal Reserve Bank of St. Louis REVIEW
November/December 2013
467
468
November/December 2013
Federal Reserve Bank of St. Louis REVIEW
Forces at Work: The Fed, Money, and Forward Guidance
Modern-day monetary policymaking has shifted focus away from the role of monetary aggregates. But the
accepted role of money in the economy is in large part due to the efforts and leadership of Homer Jones and
Darryl Francis, president and CEO of the St. Louis Fed from 1966 to 1976. In “Darryl Francis and the Making of
Monetary Policy, 1966-1975,” David Wheelock and R. W. Hafer document how Francis argued that the main
determinant of inflation over medium and longer terms was the Fed’s monetary policy. He argued that the
main reason for the high and rising inflation was the Fed’s misplaced attempt to lower unemployment and that
attempting to lower unemployment caused higher inflation, which made unemployment worse over the long
haul. Under Francis’s leadership, the St. Louis Fed persuaded policymakers in the Fed and in Congress to adopt
a monetary policy strategy based on money supply targeting to eliminate the inflation problem.
The reality of monetary targeting was much different from monetarist theory. It turned out that monetary
aggregates were difficult to control and attempting to do so caused a significant rise in the volatility of interest rates and inflation. The policy, however, did end 25 years of accelerating inflation and began the long
period of declining interest rates that continued into mid-2013. The story of Paul Volcker’s monetarist monetary policy reform is told in “The Reform of October 1979: How It Happened and Why,” by economists who
actively participated in that reform: David Lindsey, Athanasios Orphanides, and Robert Rasche. The decade
after the reform was spent trying to understand how to conduct monetary policy analysis in dynamic models
in which the central bank used interest rate rules and people behaved rationally in forming expectations and
making decisions about consumption, investment, and production. This article discusses the communication
problems the Fed experienced when it initiated a fundamental change in the direction of policy.
The next article, “Inflation Targeting in a St. Louis Model of the 21st Century,” by Robert G. King and Alex
Wolman is the first of the modern New Keynesian models that incorporated both monetarist and Keynesian
ideas in a dynamic general equilibrium model with interest rate rules. The focus of this new paradigm, which
has taken over as the primary model for conducting policy analysis in central banks, is on modeling the effects
of expectations about future monetary policy on current behavior.
The final article in this section, “Announcements and the Role of Policy Guidance,” by Carl E. Walsh explores the
effects of central bank transparency on economic uncertainty. Walsh asks what happens if the central bank
reveals its assessment of future economic activity in a world where the central bank has some inside information but it is not always accurate. The key idea in Walsh’s paper is that it is more important for the central bank
to be transparent when the underlying quality of its information is better.
Used with permission of Bloomberg L.P. Copyright© 2013. All rights reserved.
Used with permission of Bloomberg L.P. Copyright© 2013. All rights reserved.
Used with permission of Bloomberg L.P. Copyright© 2013. All rights reserved.
Used with permission of Bloomberg L.P. Copyright© 2013. All rights reserved.
Centennial Issue
Darryl Francis and the
Making of Monetary Policy, 1966-1975
R. W. Hafer and David C. Wheelock
Darryl Francis was president of the Federal Reserve Bank of St. Louis from 1966 to 1975. Throughout
those years he was a leading critic of U.S. monetary policy. Francis argued in policy meetings and public
venues that monetary policy should focus on maintaining a stable price level. In contrast, most policymakers at the time believed it possible to exploit a trade-off between unemployment and inflation. While
Francis attributed inflation directly to excessive growth of the money stock, other policymakers blamed
labor and product market failures, fiscal policy, and commodity price shocks. Francis argued that inflation could not be controlled except by limiting the growth of monetary aggregates; other policymakers
promoted price controls or other schemes. Francis favored maintaining a stable money stock growth rate
at a time when monetary policy was widely interpreted as involving the manipulation of interest rates.
Reviewing the debates between Francis and his Federal Reserve colleagues improves our understanding
of the reasons behind the Fed’s monetary policy actions at the time and illuminates how policy views
evolved within the System toward accepting price level stability as the paramount, long-run objective
for monetary policy.
This article first appeared in the March/April 2003 issue of Review.
Federal Reserve Bank of St. Louis Review, November/December 2013, 95(6), pp. 469-85.
oday, it is widely acknowledged that the fundamental mission of monetary policy is to
maintain the long-run stability of the price level. Economists and policymakers generally
agree that persistent changes in the price level (inflation and deflation) are, in the long
run, caused by growth of the money stock in excess of the growth of total output. It is thought,
moreover, that monetary policy can best promote high employment and maximum sustainable
economic growth by maintaining reasonable stability of the price level. The charter of the
T
At the time this article was written, R. W. Hafer was a professor and chairman of the Department of Economics and Finance at Southern Illinois
University at Edwardsville. David C. Wheelock was an assistant vice president and economist at the Federal Reserve Bank of St. Louis; he currently
is a vice president and deputy director of research. The authors had thanked Ted Balbach, Michael Bordo, Bob Hetzel, Garret Jones, Thomas Mayer,
Allan Meltzer, Bill Poole, Bob Rasche, and Anna Schwartz for their comments. Heidi L. Beyer provided research assistance.
This article has been reformatted since its original publication in Review: Hafer, R. W. and Wheelock, David C. “Darryl Francis and Making of
Monetary Policy, 1966-1975.” Federal Reserve Bank of St. Louis Review, March/April 2003, 85(2), pp. 1-12;
http://research.stlouisfed.org/publications/review/03/03/HaferWheelock.pdf.
© 2013, The Federal Reserve Bank of St. Louis. The views expressed in this article are those of the author(s) and do not necessarily reflect the views
of the Federal Reserve System, the Board of Governors, or the regional Federal Reserve Banks. 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.
Federal Reserve Bank of St. Louis REVIEW
November/December 2013
469
Hafer and Wheelock
European Central Bank, as well as legislation governing the behavior of central banks in several
countries, specifies price stability as the sole objective for monetary policy. The Federal Reserve,
by contrast, is assigned multiple policy objectives—“maximum employment, stable prices, and
moderate long-term interest rates” (Federal Reserve Reform Act of 1977). Nevertheless, in
recent years U.S. monetary policy has been consistent with a gradual reduction in the rate of
inflation to the point where many economists believe that price-level stability, for practical
purposes, has been achieved.
The consensus about the importance of price-level stability and the role of monetary policy
is a fairly recent development. The macroeconomic paradigm that emerged from the Great
Depression and dominated from the 1940s to about 1980 held that full employment should be
the primary objective of monetary and fiscal policy. Stabilization policy was viewed as choosing
from among a menu of unemployment and inflation rates along a stable Phillips curve. Many
economists and policymakers viewed moderate inflation as an acceptable cost of maintaining
full employment. During the 1950s the Federal Reserve frequently was criticized for paying
“excessive” attention to inflation, to the detriment of employment and output growth.
Perhaps in part a response to such criticism, in the early 1960s the Fed’s monetary policy
generally became more expansionary. Inflation began to rise in 1965 and continued to increase
through the 1970s. Unemployment fell at first, but during the 1970s the average rate of unemployment was higher than it had been during the preceding two decades. Moreover, inflation,
unemployment, and real output growth all became more variable as the average rate of inflation
increased.
Not surprisingly, the poor performance of the macroeconomy during the 1970s brought the
Federal Reserve much criticism. Among professional economists, once-dominant views about
the roles of monetary and fiscal policy began to shift. Experience demonstrated the folly of those
policies designed to exploit a trade-off between unemployment and inflation and showed that
expansionary monetary policy could not permanently lower the unemployment rate or increase
the growth rate of real output. By October 1979, when Federal Reserve officials finally resolved
to bring inflation under control, the costs of disinflating were substantially higher than they
would have been earlier in the decade when inflation was lower and less entrenched.
This paper examines alternative views about monetary policy within the Federal Reserve
System from the mid-1960s to the mid-1970s. We highlight the views of Darryl Francis, president of the Federal Reserve Bank of St. Louis from 1966 to 1975. In contrast to most of his Fed
colleagues, Francis argued that monetary policy should concentrate on halting inflation. He
believed that the influence of monetary policy on the unemployment rate was unpredictable
and at best temporary. He was an early proponent of the view that the unemployment rate (and
real output growth) tends toward a “natural” rate determined by factors outside the control of
monetary policymakers. Francis argued that the Fed should maintain a steady growth rate of
the money stock and blamed the Fed’s targeting of interest rates and money market conditions
for producing destabilizing swings in money stock growth.
Darryl Francis’s death in early 2002 prompted this historical account of his policy views and
the debates within the Fed when he was president of the St. Louis Bank.1 Reviewing the economic
events and debates of this period not only provides a better understanding of the reasons behind
470
November/December 2013
Federal Reserve Bank of St. Louis REVIEW
Centennial Issue
Figure 1
Figure 2
Inflation Rate
Unemployment Rate
Quarterly Data, Consumer Price Index, 1951-82
Quarterly Data, 1951-82
Percent Change from Year Ago
Percent
16
12
14
10
12
8
10
8
6
6
4
4
2
2
0
–2
1951 54
57
60
63
66
69
72
75
78 1981
NOTE: Shaded bars represent recessions.
0
1951 54
57
60
63
66
69
72
75
78 1981
NOTE: Shaded bars represent recessions.
the Fed’s monetary policy actions, but also illuminates how policy views within the System evolved
toward recognizing price-level stability as the principal long-run objective for monetary policy.
The next two sections set the stage for our review of Francis’s policy positions. First we summarize macroeconomic conditions from the 1950s through the 1970s, and then we describe
the development of monetary policy from 1951 to 1966, when Francis became president of the
St. Louis Fed. The subsequent section describes Francis’s views about key policy issues by drawing
extensively on his speeches and remarks at Federal Open Market Committee (FOMC) meetings.
We highlight differences between the views of Francis and the consensus of his FOMC colleagues.
MACROECONOMIC OVERVIEW
In March 1951, the Federal Reserve and U.S. Treasury reached an agreement (the “Accord”)
that freed the Fed from an obligation to maintain specific yield ceilings on U.S. government
securities. The agreement was sparked by a sharp increase in the rate of inflation in 1950 and
early 1951 and the desire of Fed officials to halt the rise by limiting the growth of bank reserves
and the money stock. Under the Accord the Fed agreed to continue to support the government
securities market temporarily when the Treasury issued new debt, but yields were permitted to
find their market levels as the Fed directed its focus toward containing inflation.
Inflation declined sharply in 1952 and remained low until 1956, as Figure 1 shows. After
reaching an annual rate of nearly 4 percent in 1957, inflation declined to under 2 percent and
remained remarkably steady until 1965. The rate of inflation then began to move upward in
Federal Reserve Bank of St. Louis REVIEW
November/December 2013
471
Hafer and Wheelock
Figure 3
Figure 4
Phillips Curve
Inflation Rate and M1 Growth
Average Annual Quarterly Data, 1960-82
Quarterly Data, 1951-82
Inflation Rate
Percent Change from Year Ago
14
16
14
12
Inflation
12
10
10
8
8
6
6
4
4
M1
2
2
0
1960-69
0
0
2
4
6
8
10
12
14
–2
1951 54
57
60
63
66
69
72
75
78 1981
successive waves, with peaks in 1970, 1974, and 1980. Each peak came during a recession and
followed deliberate actions by the Federal Reserve to tighten policy. In each successive cycle,
however, the inflation nadir and subsequent peak were higher than those associated with the
previous cycle. In 1980 the consumer price index increased at a 13.5 percent annual rate, its
highest annual rate since 1947 when wartime price controls had just been lifted.
We plot the unemployment rate over the same years in Figure 2. The unemployment rate
fluctuated considerably during the 1950s, then fell almost continuously from 1963 to 1969 to end
the decade below 4 percent. Much of the decline came as inflation was rising, suggesting that
Federal Reserve officials had revised their preferences in favor of a lower unemployment rate
and were willing to accept higher inflation as the cost of pushing the unemployment rate down.
The unemployment rate did not continue to fall during the 1970s, even though inflation
continued to rise. As Figure 2 shows, the unemployment rate increased sharply during the recession of 1970; though it declined during the subsequent recovery, it did not fall below 5 percent.
Another recession in 1974-75 pushed the unemployment rate above 8 percent. In the subsequent
recovery, the rate again fell to a low point that was higher than that of the previous expansion.
Finally, during the 1981-82 recession the unemployment rate peaked at over 10 percent—its
highest level since the Great Depression.
Although short-run peaks in the unemployment rate tended to occur when the inflation
rate was falling, the negative correlation between annual rates of unemployment and inflation
that characterized the 1960s was absent during the 1970s and early 1980s. As shown in Figure 3,
unemployment and inflation rates appear to have followed a predictable Phillips curve pattern—
higher unemployment rates associated with lower inflation—during the 1960s. From 1970 to
472
November/December 2013
Federal Reserve Bank of St. Louis REVIEW
Centennial Issue
1982, however, the correlation between unemployment and inflation rates was low. Moreover,
both rates followed upward trends over the period, which ran counter to a view commonly held
during the 1960s that expansionary monetary policy could permanently lower the average rate
of unemployment.2
It is beyond the scope of this paper to identify the sources of specific changes in inflation or
unemployment during the 1960s and 1970s. Oil price shocks in 1973 and 1979 and other supplyside disturbances are often blamed for much of the adverse movements in unemployment and
the price level during the 1970s.3 The increasing trend rate of inflation is today widely attributed
to a rising average growth rate of the money stock. The association between money stock growth
and inflation is illustrated in Figure 4, where we plot the growth rate of M1, a narrow monetary
aggregate, alongside the inflation rate.4 The figure illustrates that money growth and inflation
moved inversely in the short run, reflecting the Fed’s attempts to tighten policy in response to
higher inflation. Over the longer term, however, the upward trend in the rate of inflation was
associated with a similar trend in money stock growth. Like inflation and unemployment, M1
growth rose and fell in waves, with both growth rate peaks and troughs as high or higher than
those of the previous cycle.
MONETARY POLICY FROM THE ACCORD TO 1966
We assert that neither the trend nor the variability of money stock growth, inflation, or the
unemployment rate during the late 1960s and the 1970s reflected a well-designed monetary policy.
To provide some information on how policy decisions were made during these years, we briefly
review economic policy developments in the period preceding the “Great Inflation” of 1966-80.
During the 1950s, monetary policy focused largely on the threat of inflation. Inflation fell
sharply in 1952 when the Fed began to exercise its new independence. Following the 1953-54
recession, however, inflation seemed poised to increase again. Federal Reserve Chairman William
McChesney Martin vowed not to repeat the mistake of the previous expansion, when interest
rates were not increased fast enough to curb inflation. Consequently, the Fed tightened policy
in 1956 and maintained its stance even as economic activity began to slow. Although a few FOMC
members called for an easier policy, the majority thought that continued restraint was needed
to avoid “sloppy” financial markets and to contain inflationary momentum.5
The Fed’s concern about potential inflationary momentum was heightened in 1957 when,
contrary to widespread expectations, the price level failed to decline as economic activity began
to slow.6 The Fed maintained its anti-inflation posture until mid-1958, easing only when policymakers had become convinced that inflation was falling. M1 growth exceeded 6 percent during
the final two quarters of 1958 after having fallen at about a 2 percent annual rate during the first
half of that year. Monetary policy remained expansionary until late 1959 when a tighter policy
caused M1 growth to fall. The economy entered yet another recession in the second quarter of
1960.
Even though inflation had remained low, slow economic growth and recurrent recessions—
1953-54, 1957-58, and 1960-61—led to criticism of the Fed’s policies. One group of economists—
who were later labeled “monetarists”—blamed the Fed’s “stop-go” policy actions, and resulting
Federal Reserve Bank of St. Louis REVIEW
November/December 2013
473
Hafer and Wheelock
swings in money stock growth, for much of the instability in the macroeconomy.7 Other economists claimed that persistently tight monetary policy had contributed to the economy’s tepid
growth and high unemployment, though many considered monetary policy less effective than
fiscal policy for stabilizing economic activity.
The principal economic advisers in the Kennedy administration were prominent Keynesians
who favored the use of fiscal policy tools to stimulate rapid economic growth.8 In the Kennedy
administration, writes Okun (1970, pp. 40-41), “the standard for judging economic performance
[focused on] whether the economy was living up to its potential rather than merely whether it
was advancing…As long as the economy was not realizing its potential, improvement was needed
and government had a responsibility to promote it.”
The Economic Report of the President for 1962 outlined the problem as Kennedy’s advisers
saw it: “Expectations in 1962 were colored by the suspicion that underutilization was to be the
normal state of the American economy…[and] inadequate demand remains the clear and present
danger to an improved economic performance” (1963, p. 23). The Report stated explicitly that
“demands originating in the private economy are insufficient by themselves to carry us to full
employment…[and] the Federal Government can relax its restraints on the expansionary powers
of the private economy” by reducing taxes and reforming the tax system (1963, p. 32).
Where did monetary policy fit into this scheme? The consensus view, both outside and
inside the Fed, was that monetary policy should accommodate the needs of fiscal policy, which
meant keeping interest rates low. Although nominally constrained by the continuing balance of
payment deficits, monetary policy was generally consistent with the Kennedy administration’s
desires. Okun (1970, p. 55) writes that “the Fed did not ‘lean against the wind’ during 1961-65.
As long as the economy continued to operate below its potential and prices remained stable, the
Fed was prepared to provide the liquidity to sustain the advance.”9
Extended summaries of the FOMC Memoranda of Discussion corroborate Okun’s view,
although there probably was more concern expressed about a possible resurgence of inflation in
FOMC deliberations than in White House meetings. For example, at an FOMC meeting on
December 17, 1963, Federal Reserve Chairman Martin commented that the “whole western
world was again faced with the specter of inflation…and he was opposed to inflation because
it led to deflation. There were those who believed that unemployment could be cured by easy
money. He doubted this…Budget, fiscal and wage-price policies had more fundamental effects”
(FOMC, December 17, 1963, p. 55-56).10
The Phillips curve was cemented firmly into the policy calculus of administration advisers
and many Federal Reserve economists.11 Using this framework, the president’s advisers estimated
that if the economy were operating at its potential, the unemployment rate would be approximately 4 percent and the inflation rate would be about 2 percent.12 Fiscal and monetary policies
were not considered adequately expansionary if the unemployment rate rose above 4 percent.
After declining steadily since 1961, full employment (i.e., a 4 percent unemployment rate)
was achieved in 1965. Although many economists and policymakers recognized that expansionary policies could lead to higher inflation, consumer price inflation appeared to be contained.
Wholesale prices, however, began to rise rapidly in 1965. With federal budget deficits also expanding, fears of higher inflation were ignited. Nevertheless, by September 1965, Fed Chairman
474
November/December 2013
Federal Reserve Bank of St. Louis REVIEW
Centennial Issue
Martin opined that price pressures were not sustainable and that “it would be desirable to keep
to the status quo, with the [Open Market] Desk maintaining market conditions on as even a
keel as possible at this juncture” (FOMC, September 28, 1965, p. 94).
Martin’s views changed quickly. Inflation became more apparent as 1965 was drawing to a
close. Despite pressure from the White House, Martin and other Fed officials began to advocate
a more restrictive policy.13 Martin stated at an FOMC meeting in late November that “if any
Reserve Bank should come in with an increase in the discount rate he would be prepared to
approve” (FOMC, November 23, 1965, p. 87). On December 6, 1965, the discount rate was
increased from 4 to 4.5 percent. The Board of Governors was deeply divided over the increase—
four members voted to approve the increase and three opposed. The Johnson administration
and some members of Congress were publicly critical of the Fed’s move, with some administration officials even questioning whether the Fed should have the power to act independently.14
Foreshadowing later episodes, the Fed’s effort to contain inflation was short-lived. Monetary
policy tightened further in mid-1966, but the Fed soon relented under pressure that intensified
when interest-sensitive sectors of the economy began to show signs of weakness. By early 1967
monetary policy, as measured by the growth of monetary aggregates, had once again become
extremely expansionary.15
THE FRANCIS YEARS
Darryl Francis became president of the Federal Reserve Bank of St. Louis in 1966. In the
tradition of his predecessors, he was an outspoken critic of the Fed’s monetary policies.16 Francis
strongly supported the goal of halting inflation, but felt that the Fed’s actions in late 1965 and
early 1966 had been too timid. At an FOMC meeting on May 10, 1966, he noted that the monetary aggregates were continuing to grow rapidly, which he attributed to the Fed’s reluctance to
allow interest rates to rise. At the subsequent FOMC meeting on June 28, he pointed out that
“while it was generally believed that interest rates had been rising in a restrictive manner during
the past year, they had, in a very real sense, not done so. The cost of money to the borrower and
the return to the saver were affected by changes in the value of the dollar. When one adjusted
market interest rates for the decline in the value of the dollar [i.e., for inflation]…one found that
interest costs had not risen at all in the past year…During the year market interest rate increases
had provided no restriction to the excessive total demand” (FOMC, June 28, 1966, p. 65).
Measured by Francis’s preferred gauge of monetary policy—the growth of monetary aggregates—policy became considerably tighter as 1966 progressed. By autumn, Francis voiced concerns that monetary policy had become too tight: “Monetary developments since last spring had
been restrictive…Member bank reserves had declined moderately, growth of bank credit had
slowed markedly, and the money supply had changed little on balance…Care now had to be taken
to avoid becoming too restrictive…Steps should be taken to avoid any sustained monetary contraction, as well as to avoid a renewal of the rapid monetary expansion that occurred last winter
and spring” (FOMC, November 1, 1966, pp. 78-79).
Francis’s statements at FOMC meetings during his first year in office reflected fundamental
views about monetary policy that he shared with other monetarists. The quotes above, for examFederal Reserve Bank of St. Louis REVIEW
November/December 2013
475
Hafer and Wheelock
ple, illustrate his belief that the stance of monetary policy is measured appropriately by the growth
rates of monetary aggregates, not the level of interest rates, and that the Fed should keep the
money stock growing at a steady pace, rather than allow it to fluctuate widely. His calls for targeting the money stock growth rate and for focusing monetary policy exclusively on containing
inflation, while gaining some support in academic circles, put him at odds with most of his Fed
colleagues. In this section, we examine Francis’s policy pronouncements in detail and how they
challenged the prevailing consensus among Federal Reserve policymakers.17
Monetary Policy and Employment
Many of Francis’s policy views would not be controversial today, but fell outside the mainstream during his tenure at the Fed. For example, a dominant view among macroeconomists at
that time was that the government should respond to any shortfalls in employment or output
growth. The Fed was widely accused of having been overly concerned with preventing inflation
during the 1950s, which many economists claimed had kept the unemployment rate higher than
necessary.18 Although reasonable stability of the price level was seen as desirable, many economists and policymakers argued that modest inflation was an acceptable cost of achieving high
employment. Moreover, many claimed that any inflation that did occur when the economy was
at less than full employment was due not to monetary policy but to “excessive” increases in wages
or other costs.
Although widely held, the mainstream views about inflation and the role of monetary policy
did not go unchallenged. Friedman (1968) and Phelps (1967) argued that the unemployment rate
would tend toward a “natural rate” in the long run, irrespective of the rate of inflation. Friedman
preached that “inflation is always and everywhere a monetary phenomenon” and argued that
fluctuations in money stock growth historically had been a principal cause of short-run fluctuations in real output and employment. By fixing money stock growth at the long-run growth rate
of real output (adjusted for the trend growth of velocity), Friedman claimed that the price level
would remain stable and monetary policy would not contribute to business cycle fluctuations.19
Francis shared many of Friedman’s views and advocated them in policy discussions. Francis
decried attempts to use monetary policy to control the unemployment rate, claiming that “Use
[of monetary policy] as a short-run stabilizing tool produces costs in terms of lost employment
and output and undesired price level movements” (1972, p. 34). Further, he argued, “I am convinced that future stabilization of our economy depends heavily upon a moderate and stable
growth of the money stock. But if the pronouncements of critics of the monetarist view are heeded,
the result will most likely be erratic fluctuations in the money stock caused by attempts to ‘fine
tune’ the economy. Such fluctuations will necessarily cause periods of inflation and will be frequently accompanied by unacceptable levels of unemployment” (1972, p. 38). In Francis’s view,
“stop-go” monetary policy, by which he meant abrupt shifts from slow to rapid growth of the
money stock, was an important cause of fluctuations in output growth and inflation: “Only by
eliminating the stop-go stabilization actions…could [monetary] policy makers permanently
improve the total social welfare and avoid acting as the architects of successive waves of intensifying inflation and recession” (FOMC, April 6, 1971, pp. 77-78).
476
November/December 2013
Federal Reserve Bank of St. Louis REVIEW
Centennial Issue
Today, Francis might be described as an inflation “hawk” because he often argued that monetary growth was too fast and inflation too high. In the fall of 1966 and again in October 1969,
however, Francis pressed for an easier monetary policy because he believed that monetary growth
was too slow and the danger of recession was high. On the latter occasion he argued that “The
studies made at his Bank indicated…that, if the System did not permit some growth in key monetary aggregates beginning now, an unacceptable economic recession would most likely develop
in 1970, which in turn might force the Committee into [an] inordinate monetary expansion”
(FOMC, October 28, 1969, pp. 54).20 Francis was prescient: The U.S. economy entered a recession in the fourth quarter of 1969.
Francis attributed the increasing trend rate of inflation that began in the mid-1960s to the
Fed’s persistent attempts to hold the unemployment rate below a level consistent with price stability. At the time, the consensus among most policymakers and economists was that a 4 percent
unemployment rate represented full employment. In hindsight, it is now widely believed that
the “natural rate” was really 5 percent or higher throughout the 1970s.21 Even though Francis
probably had no more insight about the natural rate of unemployment than any other Fed policymaker, as early as 1970 he questioned whether a 4 percent rate of unemployment could be achieved
without generating higher inflation: “When spending was rising fast enough to keep the unemployment rate at about 4 percent, strong upward pressure was exerted on prices and price expectations…Much of the current unemployment was structural and could not be obviated except
temporarily and with adverse price effects by stimulation of total spending” (FOMC, August 18,
1970, pp. 44-45). In 1971 he again noted that “In the last decade whenever the unemployment
rate had been below 5 percent inflation had accelerated, largely because of labor market imperfections” (FOMC, April 6, 1971, p. 30).
The Cause or Causes of Inflation
Friedman and other monetarists believed that the impact of monetary policy on real output
and employment was transitory: Over time, monetary policy affected only the price level, while
sustained movements in the price level were caused solely by growth of the money stock in excess
of total output growth. At the time, however, many economists and policymakers attributed
inflation to imperfections in labor or product markets, expansionary fiscal policy, shortages of
raw materials, and other nonmonetary forces. Federal Reserve Chairman Arthur Burns, for
example, blamed the inflation of the 1970s on increases in wages and other costs in excess of
productivity gains. In a speech given in December 1970, Burns complained that “Governmental
efforts to achieve price stability continue to be thwarted by the continuance of wage increases
substantially in excess of productivity gains…The inflation that we are still experiencing is no
longer due to excess demand. It rests rather on the upward push of costs—mainly, sharply rising
wage rates.” He argued, moreover, that “Monetary and fiscal tools are inadequate for dealing
with sources of price inflation such as are plaguing us now—that is pressures on costs arising
from excessive wage increases” (Burns, 1978, pp. 112-13).22
Burns often made similar comments at FOMC meetings. For example, at a meeting on
April 7, 1970, he suggested that “The inflation that was occurring—and that was now being
accentuated…was of the cost-push variety. That type of inflation…could not be dealt with sucFederal Reserve Bank of St. Louis REVIEW
November/December 2013
477
Hafer and Wheelock
cessfully from the monetary side and it would be a great mistake to try to do so” (FOMC, April 7,
1970, p. 50). Whereas Burns viewed wage increases as the dominant cause of inflation during
the 1970s, he blamed expansionary fiscal policy for the initial increase in inflation during the
mid-1960s: “The current inflationary problem emerged in the middle 1960s when our government was pursuing a dangerously expansive fiscal policy …Our underlying inflationary problem…stems in very large part from loose fiscal policy” (Burns, 1978, p. 177).23
Francis disagreed. Unlike some of his contemporaries on the FOMC, Francis did not confuse
changes in relative prices with persistent increases in the general level of prices. While monetary
policy could affect the latter, changes in relative prices were caused by market forces beyond the
Fed’s control. In a February 1972 speech, for example, Francis argued that “In the long run the
growth of output and employment is determined by the growth of resources of a society…The
trend growth of prices is determined by the trend growth of money stock relative to growth in
output…Deviations from a trend rate of growth of money…cause short-run deviations in output
and employment…But once the adjustment is completed, output and employment will resume
their longer-run growth paths” (Francis, 1972, p. 33). In another speech, Francis noted that “other
factors have an influence on the movement of prices in a given year. But when we talk about the
‘problem of inflation,’ I think it is safe to say that the fundamental cause is excessive money growth”
(Francis, 1974, pp. 6-7).24 As a policy issue, the distinction between changes in relative prices
and inflation became even more important when petroleum prices increased sharply in 1973.
The Cure for Inflation
In light of their differing views about the cause of inflation, not surprisingly Burns and
Francis disagreed about how to end inflation. By the late 1960s inflation clearly was on an upward
trend. As Francis pointed out in early 1969, “For about four years…the [Federal Open Market]
Committee had been led into unintended inflationary monetary expansion while following
interest rate, net reserves, and bank credit objectives and the even keel constraint. He suggested
that, if the Committee meant business now, it should try some other guides” (FOMC, February 4,
1969, p. 47). Specifically, Francis sought an operating procedure that focused on controlling the
growth of money. His view, from which he did not waver during his ten years on the FOMC, was
that “the cure [for inflation] is to slow down the rate of money expansion” (Francis, 1974, p. 7).
In contrast, Burns, other members of the FOMC, and administration economists promoted
wage and price controls as the only viable policy for stopping inflation. “The persistence of rapid
advances of wages and prices in the United States and other countries, even during periods of
recession,” Burns argued, “has led me to conclude that governmental power to restrain directly
the advance of prices and money incomes constitutes a necessary addition to our arsenal of economic stabilization weapons” (Burns, 1978, p. 156).25 At an FOMC meeting on June 8, 1971,
Burns argued that “Monetary policy could do very little to arrest an inflation that rested so heavily
on wage-cost pressures...A much higher rate of unemployment produced by monetary policy
would not moderate such pressures appreciably...He intended to continue to press [the administration] hard for an effective incomes policy” (FOMC, June 8, 1971, p. 51). On August 15 of that
year, President Nixon unveiled his New Economic Program and introduced the first of three
phases of direct wage and price controls.
478
November/December 2013
Federal Reserve Bank of St. Louis REVIEW
Centennial Issue
Francis was highly critical of government controls on prices and wages, as they simply disrupted market signals. At an FOMC meeting in December 1967, he suggested that “Selective
credit controls, wage freezes, and price restrictions had been advocated as alternatives [to contain inflation]. Such controls, however…raised problems of resource allocation; they interfered
with freedom; and they were difficult to administer” (FOMC, December 12, 1967, pp. 54-55).
In December 1970, Francis again argued at an FOMC meeting that “The adoption of administrative controls in attempting to hold down inflation, or to shorten the period of adjustment, would
impose a great cost on the private enterprise economy. Serious inefficiencies would develop in
the operations of the market system” (FOMC, December 15, 1970, p. 74). While such controls
might mask inflation for a time, “a freeze or other control programs could not be expected to
effectively restrain inflation unless accompanied by sound monetary actions” (FOMC, October
19, 1971, p. 36). In Francis’s view, low rates of inflation could not be achieved over the long run
unless the money stock grew at a rate approximately equal to the long-run growth rate of real
economic activity. Wage and price controls, to Francis, were merely impediments to the efficient
working of a free market.
Money Versus the Money Market
The money stock did not grow at anything like the steady rate that Francis and other monetarists advocated. They attributed wide swings in money growth to the Fed’s strategy of targeting
market (i.e., nominal) interest rates. During World War II and for several years afterward, Federal
Reserve open market operations were aimed primarily at maintaining low and stable yields on
U.S. Treasury securities. The Federal Reserve–Treasury Accord of 1951 removed the Fed’s obligation to maintain ceilings on Treasury security yields, but both yields and the general “condition” of the Treasury securities market remained important concerns of open market policy. In
particular, the Fed typically would act to prevent market yields from changing whenever the
Treasury issued new debt—a policy known as maintaining an “even keel.”
The Fed used this “money market” strategy to implement policy throughout the 1950s,
1960s, and 1970s. Francis was highly critical of the approach because it detracted from his preferred policy of stable growth of the money stock.26 Moreover, he eschewed the use of market
interest rates as a guide for policy because their movement did not always reflect policy actions.
While rising interest rates often were considered a sign of monetary policy tightening, Francis
noted that rising rates also could reflect rising inflation, the outcome of an expansionary monetary policy.
From the first FOMC meetings he attended, Francis chided the Committee for previous
policies that, in his view, contributed to uncertainty over the stance of policy. For example, at a
meeting on May 10, 1966, Francis observed that “There had now been ten or eleven months
when the directive had continuously called for a moderation or restriction of expansion in bank
reserves, bank credit, and money, and at the same time called for only slightly firmer money
market conditions. Those instructions [have] been inconsistent…[and have led to] very rapid
increases in bank reserves, bank credit and the money supply” (FOMC, May 10, 1966, p. 49). He
expressed this view often during the late 1960s, both at FOMC meetings and in public forums.
Speaking to a group of financial market practitioners in New York City in 1968, Francis argued
Federal Reserve Bank of St. Louis REVIEW
November/December 2013
479
Hafer and Wheelock
that “Measures of money market conditions such as market interest rates and free reserves have
been shown to be poor indicators of the influence of monetary actions.” And, “for stabilization
purposes, movements in interest rates should be viewed no differently than movements in commodity prices” (Francis, 1968, p. 8).
The FOMC never abandoned money market conditions or interest rates as policy targets. In
1970, however, FOMC policy directives began to include specific targets for the growth of money
and bank credit, as well as for money market conditions. Frequently the objectives for money
and credit were in conflict with those specified for interest rates, and the latter were usually permitted to take precedence. Citing such conflicts, Francis voted against two policy directives in
1973 because he did not believe that the monetary growth rates specified in those directives—
which he agreed with—would be achieved given the money market objectives the directives also
specified.27 The failure to achieve the monetary growth objectives set by the FOMC led Francis
to argue for making public the FOMC’s targets and its record of achieving those targets: “The
records should contain a clearer description of the whole process of making and implementing
policy, including information on targets that were missed and on those that were hit” (FOMC,
December 17, 1973, p. 14).
In contrast to Francis, most FOMC members were unwilling to discard interest rates or
money market conditions as proximate objectives for monetary policy. Burns sometimes made
statements at FOMC meetings favoring tighter control of the growth of monetary aggregates.
He more frequently spoke against monetarist policy prescriptions, however, both at FOMC meetings and in public comments. For example, at an FOMC meeting in early 1971, Burns argued
that “the heavy emphasis that many people were placing on the behavior of M1 involved an
excessively simplified view of monetary policy” (FOMC, February 9, 1971, p. 87). And, in congressional testimony in 1975, he stated: “There is a school of thought that holds that the Federal
Reserve need pay no attention to interest rates, that the only thing that matters is how this or
that monetary aggregate is behaving. We at the Federal Reserve cannot afford the luxury of any
such mechanical rule…We pay close attention to interest rates because of their profound effects
on the working of the economy” (Burns, 1978, p. 369).28
Supply Shocks
Francis’s policy views were shaped and supported by considerable empirical research conducted by St. Louis Fed staff, as well as economists outside the System. The St. Louis Fed formulated a simple, yet highly accurate forecasting model and began to publish forecasts in the Bank’s
Review in April 1970 (Andersen and Carlson, 1970). Like other models, however, the St. Louis
model seriously under-forecast inflation in 1973-74 and the decline in real economic activity in
1974-75. Burns noted this in testimony before the House Committee on Banking and Currency
in July 1974: “Inflationary tendencies and monetary expansion are not as closely related as is
sometimes imagined. For example, the econometric model of the St. Louis Federal Reserve Bank,
which assigns a major role to growth of the money stock in movements of the general price level,
has seriously underestimated the rate of inflation since the beginning of 1973…Apparently,
special factors…have been at work” (Burns, 1978, p. 176).29
480
November/December 2013
Federal Reserve Bank of St. Louis REVIEW
Centennial Issue
Francis acknowledged that “With respect to inflation…the rise in prices in 1974 was just
about double the increase that he would have expected to result from the policy actions that had
been taken. Special factors, such as the energy and agricultural problems, had contributed to the
rise in prices in 1974” (FOMC, December 17, 1974, p. 99). Francis reiterated his earlier position
that observed changes in the price level caused by changes in relative prices associated with supply disturbances could not persist indefinitely. As he had argued almost a decade earlier, over
time inflation was a monetary phenomenon. In a speech in October 1974, for example, he stated
that he was “not willing to accept the special factor explanation of inflation because that explanation removes the focus from inflation as a monetary phenomenon” (Francis, 1974, p. 5).
In policy discussions, Francis warned against tightening excessively in response to a temporary increase in the price level caused by supply shocks, claiming that the special “factors would
not continue to exert strong upward pressure [on inflation] in 1975, and the rate of inflation
would subside” (FOMC, December 17, 1974, p. 99). At the same time, however, he also warned
against excessive easing in response to the ongoing recession because it too had been caused by
the supply shocks and not a lack of demand. At an FOMC meeting in January 1974, he argued
that “the actual and prospective slowdown in economic activity resulted wholly from capacity,
supply, and price-distorting constraints and not from a weakening in demand. Therefore, to ease
policy and allow a faster rate of monetary growth would be to increase inflationary pressures
without expanding real output or reducing unemployment” (FOMC, January 22, 1974, p. 102).
And, in December of that year, he argued that “The current decline in economic activity differed
from past recessions in a number of respects. First, it was one of the few declines, if not the only
one, to have developed without having been preceded by stabilization policy actions that brought
it about. Second, there had been an absolute decline in the country’s capacity to produce, caused
by the agricultural and energy problems, by the distortions resulting from the wage and price
controls, by the new environmental and safety standards, and by changes in foreign exchange
rates” (FOMC, December 17, 1974, p. 99). Rapid money stock growth, Francis argued, could do
little to affect the growth of real output or employment in such a circumstance and would result
mainly in a higher rate of inflation.
CONCLUSION
Darryl Francis served as president of the Federal Reserve Bank of St. Louis during tumultuous economic times. Even so, Francis’s views about monetary policy reflected an underlying
set of beliefs from which he did not waver. The “four basic premises” that guided him in his
policy prescriptions were set out in an early speech and reprinted in the Federal Reserve Bank
of St. Louis Review in 1968 (Francis, 1968). These premises are as follows: “First, a predominantly
market orientation.” Francis firmly believed in the unequaled efficiency of free markets to allocate incomes and goods and services. “Second, quantification is essential.” In contrast to most of
his FOMC colleagues, Francis consistently fought for quantifiable policy rules and measures of
the success or failure of policy actions. “Third, our economic system is more stable than was
believed a few years ago.” Francis believed that, over time, real economic growth was determined
by population growth, capital formation, and technology. Monetary policy, in his view, could not
Federal Reserve Bank of St. Louis REVIEW
November/December 2013
481
Hafer and Wheelock
reliably improve on market outcomes in the short run, or increase real output growth (or lower
the unemployment rate) in the long run. Although not the accepted wisdom in his time, such a
view today is fundamental. “Fourth, monetary management is more properly directed toward
influencing changes in total spending.” Francis questioned attempts to use monetary or fiscal
policies to affect specific markets or sectors of the economy. Although actions taken to achieve
price stability could impinge more on some sectors than on others, Francis argued that free
markets would adjust to such actions. Allocation of goods and services or resources by market
forces, he believed, was preferable to allocation by government decree.
Francis did not think about monetary policy in terms of forward-looking, dynamic rules or
deep theoretical models. He had strong convictions about the efficacy of market forces and the
limitations of government stabilization policies. Even though Francis believed that monetary
policy could exert a powerful short-run impact on the unemployment rate, he was convinced
that it could not be used to permanently steer the economy to any particular rate of growth. In
the long run, Francis believed that monetary policy affected only the price level. Maintaining
price stability, Francis believed, would help establish conditions that would foster maximum
employment and economic growth. Although not widely shared among his contemporary
Federal Reserve colleagues, today such views are mainstream. ■
NOTES
482
1
We focus on Francis’s professional contributions. For more personal reflections, see Poole (2001, 2002) and Jordan
(2001).
2
Hafer and Wheelock (2001) provide a summary of alternative views during the 1960s about the association between
inflation and unemployment in the long run.
3
See Barsky and Kilian (2001) for an alternative view.
4
We plot M1 growth because it was the aggregate favored by Darryl Francis and Federal Reserve Bank of St. Louis
staff. M2 growth behaved similarly, however, during the period illustrated here.
5
Stein (1969) notes that the Fed was supported in its policy by the Eisenhower administration and by many in the
academic community.
6
The business cycle peaked in August 1957, and the downturn continued to April 1958. A common view at the time
was that this recession was “only an interruption in the inflationary pressure, and the fact that it did not result in any
decline of the price indexes was considered highly ominous” (Stein, 1969, p. 319).
7
The FOMC focused on interest rates and free reserves (i.e., excess less borrowed reserves), not money stock growth,
in its policy deliberations. When the Fed desired a tighter policy, it would use open market operations to reduce (or
limit the growth of ) bank free reserves to increase the market yields on Treasury securities. Similarly, to ease monetary policy, the Fed would increase free reserves to reduce market yields. Friedman (1960) and Brunner and Meltzer
(1964), among others, argued that this approach caused undesirable swings in money stock growth that interfered
with the Fed’s ability to achieve the broad policy objectives of price stability, low unemployment, and economic
growth.
8
The belief that fiscal policy was a potent tool in economic stabilization was not confined to the White House. Fed
Chairman Martin (1961, p. 279), testified to the Joint Economic Committee on March 7, 1961, that in the fight against
inflation “undue reliance has perhaps been placed on monetary policy. I can readily agree with those who would
have fiscal policy…carry a greater responsibility for combating inflation.”
November/December 2013
Federal Reserve Bank of St. Louis REVIEW
Centennial Issue
9
The March 26, 1963, FOMC meeting, which ended in agreement to not change course, produced a policy directive
that is representative of the times: “This policy [to accommodate moderate growth in bank credit and minimize
capital outflows] takes into account the continuing adverse United States balance of payments position and the
increases in bank credit, money supply, and the reserve base in recent months, but at the same time recognizes the
limited progress of the domestic economy, the continuing underutilization of resources, and the absence of general
inflationary pressures” (FOMC, 1963, p. 47).
10 The Memoranda of Discussion are not verbatim transcripts of FOMC meetings, but rather summaries of statements
made by meeting participants.
11 Some administration advisers helped develop the Phillips curve for policy use. See, for example, Samuelson and
Solow (1960). See Taylor (1997) for a discussion of how use of the Phillips curve led to an inflation bias in policy.
12 See Hetzel (1995) for additional detail. The impression one gets from interviews with former Fed officials is that the
FOMC did not explicitly use the Phillips curve in its discussions. Still, the policy discussion available in the FOMC
Memoranda of Discussion suggests that such a trade-off was recognized and affected policy decisions. See Mayer
(1995, 1999).
13 St. Louis Fed president Harry Shuford, Francis’s predecessor, argued for monetary restraint at an FOMC meeting on
November 2, 1965. He and a few others recognized that “The economy was operating near capacity, and at this time
the rate of increase in spending appeared to be faster than the growth in ability to produce” (FOMC, 1965, p. 23). Fed
Governor Charles Shepardson concurred, stating that “the rate of recent expansion was unsustainable, and at some
point steps must be taken to try to dampen it” (FOMC, 1965, p. 34).
14 For example, Gardner Ackley, Chairman of the Council of Economic Advisers, argued that “The Federal Reserve
System is part of the government, and should be responsible to the administration” (cited in Hetzel, 1995, p. 19).
15 See Cagan (1972) for a detailed discussion of monetary policy during this period.
16 Francis’s predecessors at the St. Louis Bank, Delos Johns and Harry Shuford, also argued for the use of monetary
aggregates in the conduct and description of policy. This tradition no doubt reflected the influence of Homer Jones,
who was the director of research at the St. Louis Fed from 1958 to 1971. Jones’s influence is examined in a special
volume of the Journal of Monetary Economics (1976).
17 Although Francis’s intellectual debt to his research staff and others should not be ignored, it was Francis who advo-
cated these unpopular ideas and new research results in FOMC policy discussions and public venues.
18 For example, see the views expressed by participants in a symposium on (then) recent monetary policy in the Review
of Economics and Statistics (1960).
19 See, for example, Friedman (1960) or Friedman and Schwartz (1963).
20 Francis often cited and introduced into the record of FOMC meetings research results produced by his research staff.
Of these, perhaps the most controversial was that of Andersen and Jordan (1968).
21 For example, the Economic Report of the President for 1977 recognized that productivity growth had slowed substan-
tially in the late 1960s and estimated that the “full employment rate of unemployment” was approximately 5.5 percent (1978, pp. 45-57).
22 Burns made these statements in a speech titled “The Basis for Lasting Prosperity,” given December 7, 1970.
23 Burns made this statement in a speech titled “Key Issues of Monetary Policy,” given July 30, 1974.
24 Even though Burns later admitted that “Inflation cannot continue indefinitely without an accommodating increase
in supplies of money and credit” (Burns, 1978, p. 208), he argued that inflation could continue well after monetary
stimulus was removed, even during a period of rising unemployment: In 1971 he argued that “inflation caused by
excess demand became entrenched, and remained after demand-side pressures abated. Entrenched inflation,
increased militancy of labor, and willingness of business to accede to labor’s wage demands, explains continued rising prices during periods of rising unemployment” (Burns, 1978, p. 126). Burns made this statement in a speech titled
“The Economy in Mid-1971,” given July 23, 1971.
25 Burns made this statement in a speech titled “Some Problems of Central Banking,” given June 6, 1973.
26 Francis was not the first Federal Reserve Bank president to criticize the money market approach. The president of the
Federal Reserve Bank of Atlanta, Malcolm Bryan, argued against the approach in the 1950s in favor of targeting a
monetary aggregate (Meigs, 1976; Hafer, 1999).
Federal Reserve Bank of St. Louis REVIEW
November/December 2013
483
Hafer and Wheelock
27 See FOMC, July 17 and August 21, 1973.
28 Burns made this statement in testimony titled “Monetary Targets and Credit Allocation” to the Subcommittee on
Domestic Monetary Policy, U.S. House Banking, Currency, and Housing Committee, February 6, 1975.
29 Burns made this statement in testimony titled “Key Issues of Monetary Policy,” given July 30, 1974.
REFERENCES
Andersen, Leonall and Jordan, Jerry L. “Monetary and Fiscal Actions: A Test of Their Importance in Economic
Stabilization.” Federal Reserve Bank of St. Louis Review, November 1968, 50(11), pp. 11-24.
Anderson, Leonall and Carlson, Keith M. “A Monetarist Model for Economic Stabilization.” Federal Reserve Bank of
St. Louis Review, April 1970, 52(4), pp. 7-25.
Barsky, Robert B. and Kilian, Lutz. “Do We Really Know That Oil Caused the Great Stagflation? A Monetary Alternative.”
NBER Working Paper No. 8389, National Bureau of Economic Research, July 2001.
Brunner, Karl and Meltzer, Allan H. The Federal Reserve’s Attachment to the Free Reserve Concept. Washington, DC:
House Committee on Banking and Currency, 1964.
Burns, Arthur F. Reflections of an Economic Policy Maker: Speeches and Congressional Statements: 1969-1978.
Washington, DC: American Enterprise Institute for Public Policy Research, 1978.
Cagan, Phillip. “Monetary Policy,” in Phillip Cagan et al., eds., Economic Policy and Inflation in the Sixties. Washington, DC:
American Enterprise Institute for Public Policy Research, 1972, pp. 89-154.
Economic Report of the President (various years).
Federal Open Market Committee. Memoranda of Discussion (various dates).
Francis, Darryl R. “An Approach to Monetary and Fiscal Management.” Federal Reserve Bank of St. Louis Review,
November 1968, 50(11), pp. 6-10.
Francis, Darryl R. “Has Monetarism Failed?—The Record Examined.” Federal Reserve Bank of St. Louis Review, March
1972, 54(3), pp. 32-38.
Francis, Darryl R. “Inflation, Recession—What’s a Policymaker To Do?” Federal Reserve Bank of St. Louis Review,
November 1974, 56(11), pp. 3-7.
Friedman, Milton. A Program for Monetary Stability. New York: Fordham University Press, 1960.
Friedman, Milton. “The Role of Monetary Policy.” American Economic Review, March 1968, 58(1), pp. 1-17.
Friedman, Milton and Schwartz, Anna Jacobson. A Monetary History of the United States: 1867-1960. Princeton:
Princeton University Press, 1963.
Hafer, R. W. “Against the Tide: Malcolm Bryan and the Introduction of Monetary Aggregate Targets.” Federal Reserve
Bank of Atlanta Economic Review, First Quarter 1999, 84(1), pp. 20-37.
Hafer, R. W. and Wheelock, David C. “The Rise and Fall of a Policy Rule: Monetarism at the St. Louis Fed, 1968-1986.”
Federal Reserve Bank of St. Louis Review, January/February 2001, 83(1), pp. 1-24.
Hetzel, Robert L. “William McChesney Martin and Monetary Policy in the 1960s.” Unpublished manuscript, Federal
Reserve Bank of Richmond, April 1995.
Jordan, Jerry. “Darryl Francis: Maverick in the Formulation of Monetary Policy.” Federal Reserve Bank of St. Louis
Review, July/August 2001, 83(4), pp. 17-22.
Journal of Monetary Economics. “Contributions in Honor of Homer Jones.” November 1976, 2(4), pp. 431-71.
Martin, William McChesney Jr. “Federal Reserve Operations in Perspective.” Federal Reserve Bulletin, March 1961, 47(3),
pp. 272-81.
Mayer, Thomas. Interviews, special collections, general library, University of California–Davis, 1995.
484
November/December 2013
Federal Reserve Bank of St. Louis REVIEW
Centennial Issue
Mayer, Thomas. Monetary Policy and the Great Inflation in the United States: The Federal Reserve and the Failure of
Macroeconomic Policy, 1965-79. Cheltenham, UK: Elgar, 1999.
Meigs, A. James. “Campaigning for Monetary Reform: The Federal Reserve Bank of St. Louis in 1959 and 1960.” Journal
of Monetary Economics, November 1976, 2(4), pp. 439-53.
Okun, Arthur M. The Political Economy of Prosperity. Washington, DC: The Brookings Institution, 1970.
Phelps, Edmund S. “Phillips Curves, Expectations of Inflation and Optimal Unemployment Over Time.” Economica,
August 1967, 34(135), pp. 254-81.
Poole, William. “President’s Message.” Federal Reserve Bank of St. Louis Review, July/August 2001, 83(4), pp. 5-6.
Poole, William. “Eulogy for Darryl R. Francis, 1912-2002.” Federal Reserve Bank of St. Louis Review, March/April 2002,
84(2), pp. 1-2.
Review of Economics and Statistics. “Controversial Issues in Recent Monetary Policy: A Symposium.” August 1960, 42(3),
pp. 245-82.
Samuelson, Paul A. and Solow, Robert M. “Problems of Achieving and Maintaining a Stable Price Level: Analytical
Aspects of Anti-Inflation Policy.” American Economic Review, Papers and Proceedings, May 1960, 50(2), pp. 177-94.
Stein, Herbert. The Fiscal Revolution in America. Chicago: University of Chicago Press, 1969.
Taylor, John B. “America’s Peacetime Inflation: The 1970s: Comment,” in Christina D. Romer and David H. Romer, eds.,
Reducing Inflation: Motivation and Strategy. Chicago: University of Chicago Press, 1997, pp. 276-80.
Federal Reserve Bank of St. Louis REVIEW
November/December 2013
485
486
November/December 2013
Federal Reserve Bank of St. Louis REVIEW
Centennial Issue
The Reform of October 1979:
How It Happened and Why
David E. Lindsey, Athanasios Orphanides, and Robert H. Rasche
This study offers a historical review of the monetary policy reform of October 6, 1979, and discusses
the influences behind it and its significance. We lay out the record from the start of 1979 through the
spring of 1980, relying almost exclusively on contemporaneous sources, including the recently released
transcripts of Federal Open Market Committee (FOMC) meetings during 1979. We then present and
discuss in detail the reasons for the FOMC’s adoption of the reform and the communications challenge
presented to the Committee during this period. Further, we examine whether the essential characteristics
of the reform were consistent with monetarism; new, neo, or old-fashioned Keynesianism; nominal
income targeting; and inflation targeting. The record suggests that the reform was adopted when the
FOMC became convinced that its earlier gradualist strategy using finely tuned interest rate moves had
proved inadequate for fighting inflation and reversing inflation expectations. The new plan had to break
dramatically with established practice, allow for the possibility of substantial increases in short-term
interest rates yet be politically acceptable, and convince financial market participants that it would be
effective. The new operating procedures were also adopted for the pragmatic reason that they would
likely succeed.
This article first appeared in the March/April 2005 issue of Review.
Federal Reserve Bank of St. Louis Review, November/December 2013, 95(6), pp. 487-541.
Do we have the wit and the wisdom to restore an environment of price stability without impairing economic stability? Should we fail, I fear the distortions and uncertainty generated by inflation itself will greatly extend and exaggerate the sense of malaise and caution...Should we
succeed, I believe the stage will have been set for a new long period of prosperity.1
—Paul Volcker
At the time this article was written, David E. Lindsey was a former deputy director of the Division of Monetary Affairs at the Board of Governors
of the Federal Reserve System. Athanasios Orphanides was an adviser in the Division of Monetary Affairs at the Board of Governors of the Federal
Reserve System, a research fellow of the Centre for Economic Policy Research, and a fellow of the Center for Financial Studies. Robert H. Rasche
was senior vice president and director of research at the Federal Reserve Bank of St. Louis. The authors had thanked Steve Axilrod, Norm Bernard,
Carl Christ, Ed Ettin, and Allan Meltzer for comments and Stephen Gardner, April Gifford, and Katrina Stierholz for research assistance.
This article has been reformatted since its original publication in Review: Lindsey, David E.; Orphanides, Athanasios and Rasche, Robert H.
“The Reform of October 1979: How It Happened and Why.” Federal Reserve Bank of St. Louis Review, March/April 2005, 87(2, Part 2), pp. 187-235;
http://research.stlouisfed.org/publications/review/05/03/part2/Lindsey.pdf.
© 2013, The Federal Reserve Bank of St. Louis. The views expressed in this article are those of the author(s) and do not necessarily reflect the views
of the Federal Reserve System, the Board of Governors, or the regional Federal Reserve Banks. 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.
Federal Reserve Bank of St. Louis REVIEW
November/December 2013
487
Lindsey, Orphanides, Rasche
quarter-century after Paul Volcker’s monetary policy reform in October 1979, the profound significance of restoring price stability for the nation’s prosperity is widely recognized. Taming the inflation problem of the 1970s did set the stage for a long period
of prosperity, as Volcker and many others had hoped. Over the past two decades, the nation
has enjoyed greater price stability together with greater economic stability. Expansions have
been uncommonly long and recessions relatively brief and shallow (Figure 1).
The centerpiece of the reform was the abandonment of federal funds rate targeting in favor
of nonborrowed reserves targeting as the operating procedure for controlling the nation’s money
supply. This resulted in the unwelcome higher volatility of the federal funds rate (see Figure 1)
during a few years following the reform. In the prevailing environment of high and increasingly
unstable inflation, however, small adjustments in the federal funds rate had proven woefully
inadequate for reining in monetary growth.
The reforms of October run much deeper than the technical details that a mere switch in
operating procedures would suggest.2 By the end of the 1970s, the policy framework of the
Federal Reserve had inadvertently contributed to macroeconomic instability. The break in operating procedures facilitated a salutary reorientation of policy strategy, one focusing on the critical
role of price stability for achieving and maintaining the System’s objectives. This study offers a
historical review of the monetary policy reform of October 6, 1979, and examines the reasons for
and lessons from that experience in this broader context of the Federal Reserve’s policy strategy.
The paper is organized in five sections. The first section, How It Happened, lays out the historical record from the start of 1979 through the spring of 1980, relying almost exclusively upon
contemporaneous sources and with deliberately minimal editorial comment. An important
new source for this historical description is the transcripts of Federal Open Market Committee
(FOMC) meetings during 1979. These transcripts, which only recently became publicly available,
prove especially valuable for assessing the reasoning behind FOMC actions. The second section,
Why?, presents and discusses 12 reasons for the FOMC’s adoption of the reform, approximately
in order of increasing subtlety. The third section looks at the communications challenge presented
to the Committee during this period, and asks whether “What We Have Here Is a Failure to Communicate!” Or Not! The fourth section asks Was Chairman Volcker…A Monetarist? A Nominal
Income Targeter? A New, Neo, or Old-Fashioned Keynesian? An Inflation Targeter? or A Great
Communicator? The final section concludes.
A
HOW IT HAPPENED
In the first half of 1979, the Board of Governors of the Federal Reserve System (BOG) under
Chairman G. William Miller was short-handed and inexperienced, while the FOMC was deeply
divided over the economic outlook, its primary policy objective, and its appropriate tactics. At the
beginning of the year there were two vacancies on the Board, as Governor Jackson had resigned
on November 17, 1978, and two days later Vice Chairman Gardner died. The two vacancies
remained until one was filled by the appointment of Governor Rice on June 20, 1979.
Of the five members of the Board on January 31, 1979, Governor Wallich, who had taken
office in March 1974, had the longest tenure. Two governors, Chairman Miller, and Governor
488
November/December 2013
Federal Reserve Bank of St. Louis REVIEW
Centennial Issue
Figure 1
Real GDP Growth, Inflation, and the Federal Funds Rate
Real GDP Growth
Percent
10
Quarterly
October 1979
8
6
4
2
0
–2
1955
1959
1963
1967
1971
1975
1979
1983
1987
1991
1995
1999
2003
1963
1967
1971
1975
1979
1983
1987
1991
1995
1999
2003
1963
1967
1971
1975
1979
1983
1987
1991
1995
1999
2003
Inflation
Percent
16
Quarterly
14
CPI
GDP Deflator
Core PCE
12
10
8
6
4
2
0
1955
1959
Federal Funds Rate
Percent
20
Monthly
15
10
5
0
1955
1959
Federal Reserve Bank of St. Louis REVIEW
November/December 2013
489
Lindsey, Orphanides, Rasche
Figure 2
Average Tenure of Federal Reserve Board Members (as of January 31 of Year Shown)
Years
10
8
6
4
2
1938
1944
1950
1956
1962
1968
1974
1980
1986
1992
1998
2004
Teeters, each had less than a year of service. The average tenure on that date was about 2.7 years,
which was among the shortest on record (Figure 2).3
At the year’s first FOMC meeting in February, the Board staff indicated in the Greenbook
that they expected real growth to slow, unemployment to rise, and, as a consequence of the
increasing labor-market slack, the inflation rate to decline (BOG, 1979b, p. I-5). (Figure 3 shows
the Greenbook forecasts through September and the staff ’s forecast prepared right after the
October 6 reform.) Through May, the staff forecast for real growth and unemployment stayed
essentially unchanged, but the inflation outlook deteriorated appreciably.4
Board members and Reserve Bank presidents initially were about evenly split on the outlook
for continued real growth versus recession, but on balance they became increasingly pessimistic
as time passed. At the February 1979 meeting at least six individuals indicated that they felt a
recession during that year was possible. At the same meeting at least nine other individuals indicated that they agreed with the staff forecast of no recession, or thought that the outlook was for
strong growth, or thought the most pressing issue was the inflation rate (FOMC, Transcript,
2/6/1979, pp. 10, 12, 22-23). But by the March meeting, the sentiment among the governors and
presidents for continuing growth was already souring; by then at least nine individuals predicted
a recession before the end of the year. By the May meeting, at least eight individuals felt that the
economy either already was in recession or close to a cyclical peak.
In early July, the Greenbook assessed that a recession had already started by the second
quarter, and it was projected to persist to the end of the year. The Board apparently held a similar
490
November/December 2013
Federal Reserve Bank of St. Louis REVIEW
Centennial Issue
Figure 3
Evolution of Greenbook Forecasts During 1979
Inflation (GNP Implicit Deflator)
Percent
11
10
11
Jan. 31
March 14
10
11
April 11
May 16
July 3
Aug. 8
10
11
9
9
9
9
8
8
8
8
7
7
7
7
6
6
1979
6
1979
1980
6
1979
1980
Sept. 12
Oct. 12
10
1979
1980
1980
Real GNP Growth
Percent
6
4
6
Jan. 31
March 14
4
6
April 11
May 16
4
2
2
6
July 3
Aug. 8
4
2
2
0
0
0
0
–2
–2
–2
–2
–4
–4
1979
–4
1979
1980
1980
Sept. 12
Oct. 12
–4
1979
1980
1979
1980
Unemployment Rate
Percent
9
8
9
Jan. 31
March 14
8
9
April 11
May 16
8
9
July 3
Aug. 8
8
7
7
7
7
6
6
6
6
5
5
1979
1980
5
1979
1980
Sept. 12
Oct. 12
5
1979
1980
1979
1980
view, as the July 17 Monetary Policy Report indicated that the projection of Board members for
real gross national product (GNP) growth over 1979 was –2 to –½ percent (BOG, 1979a, p. 76).
All the while, inflation was worsening further, in part due to the rapid increase in energy prices.
Private forecasts of economic activity were no less pessimistic. Indeed, the Blue Chip Consensus
forecast pointed to a recession even before the staff did, starting in May. Such forecasts of recession accompanied by increasingly virulent inflation remained a recurrent theme both in the
Greenbook and in the Blue Chip Consensus forecasts for the remainder of the year.
The deteriorating inflation situation and the increasing pessimism about prospective real
growth produced different opinions at the FOMC table as to the appropriate focus of policy. One
group was quite vocal that priority had to be assigned to addressing inflation; a second group
was equally vociferous that priority instead should be given to mitigating the risk of economic
weakness. The conflict posed a difficult situation for Chairman Miller, who appears to have viewed
Federal Reserve Bank of St. Louis REVIEW
November/December 2013
491
Lindsey, Orphanides, Rasche
his role as that of discovering a consensus among the FOMC principals. His mode of operation
was to collect statements on the wording of a directive (in terms of growth rates of M1 and M2
and a range for the federal funds rate) and then to float a “trial balloon” to see how much support
it garnered (FOMC, Transcript, 3/20/1979, pp. 31-32). At some meetings Chairman Miller did
not even state his own view of the economic outlook or an appropriate wording for the directive.
Dissents from the directive were common, even numerous, at some of the meetings in the
first half of 1979. Four members dissented at the March meeting because they favored tighter
policy—after only one dissent, also in that direction, at the February meeting (BOG, 1979a,
pp. 142-43). Three dissents from the directive occurred in April, all toward tighter policy, and
three dissents again were recorded in May—two for easier and one for tighter policy (BOG, 1979a,
pp. 156, 165). The conference calls on June 15 and July 27 elicited one dissent each, the first in
favor of a tighter policy stance and the second in favor of an easier one (BOG, 1979a, pp. 166, 178).
Only at the July meeting was the directive adopted unanimously (BOG, 1979a, p. 178). Based on
his comments, Chairman Miller seemed frustrated by the dissents.
An ongoing issue during the first half of 1979 was whether the FOMC should frame the
operating paragraph of the directive to the Manager for Domestic Operations, System Open
Market Account, in terms of a “monetary aggregates” or a “money markets” objective. This nuance
was a significant issue in the minds of many FOMC participants. Surprisingly, considering the
extent of the internal discussion devoted to this issue, the only explicit definition or explanation
of the terminology that we have been able to find is in the staff recommendations for alternative
wording of the directive that appear in the 1979 Bluebooks. For example, in the Bluebook for the
February 1979 FOMC meeting the staff suggested both a “monetary aggregates emphasis” and a
“money market emphasis” as alternative wording for the directive. The difference seems to be
only a single phrase. The suggested wording with the monetary aggregates emphasis was this:
If, with approximately equal weight given to M1 and M2, their growth rates appear to be significantly above or below the midpoints of the indicated ranges, the objective for the funds rate is to
be raised or lowered in an orderly fashion within its range. (BOG, 1979c, p. 20)
The suggested wording for the money market emphasis was this:
If, with approximately equal weight given to M1 and M2, their growth rates appear to be close to
or beyond the upper or lower limits of the indicated ranges, the objective for the funds rate is to
be raised or lowered in an orderly fashion within its range. (BOG, 1979c, p. 20)
The distinction seemed to have hinged on whether the Manager was to react to growth of
the aggregates within the specified ranges or only when the growth of the aggregates approached
or went outside the stated ranges. But, in practice, the federal funds rate fluctuated within rather
narrow ranges under either directive. On the basis of this distinction, all of the directives from
the February through September 1979 FOMC meetings, except for that adopted at the March
FOMC meeting, were “money market directives.”
As to the actual policy stance, Chairman Miller’s tenure in 1979 included only minor tightenings—gauged by the FOMC’s funds rate objective. Two occurred on conference calls and without formal FOMC votes. They were in line with directive instructions to make small funds rate
adjustments up (or down) within a specified range to resist emerging faster- (or slower-) than492
November/December 2013
Federal Reserve Bank of St. Louis REVIEW
Centennial Issue
specified growth in the monetary aggregates. The first took place on April 27, when the funds
rate objective went from a range of 10 to 10⅛ percent to 10¼ percent, and the second on July 19,
when the FOMC raised the target to 10½ percent. On the next day, the Board unanimously voted
to hike the discount rate ½ percentage point to 10 percent. Miller’s departure to the Treasury
was announced on July 19 and took place when Chairman Volcker was sworn in on August 6.
When Miller went to the Treasury, the Trading Desk, acting between Committee meetings in
accord with directive instructions from the FOMC, was pursuing an increased federal funds rate
objective of 10⅝ percent or a shade higher, compared with 10 percent or slightly higher as the
year began.
Vice Chairman Volcker’s impression of emerging macroeconomic problems remained
remarkably constant during G. William Miller’s chairmanship in 1979. Such a conclusion can be
drawn from Volcker’s comments at the February, March, April, and May meetings of the FOMC.
Vice Chairman Volcker…I continue to feel that we could have a recession, but it’s by no means
certain. I wouldn’t rule one out, by any means, in the second half of the year. But in terms of
the recession outlook itself, I think the number one problem continues to be the concern about
the price level. The greatest risk to the economy, as well as [to actual] inflation, is people having
the feeling that prices are getting out of control. (FOMC, Transcript, 2/6/1979, p. 10)
Vice Chairman Volcker…I think the odds are better than 50/50 that we’re going to run into a
recession by [year-end], and I’ve thought that for some time...Essentially, I think we’re in retreat
on the inflation side; if there’s not a complete rout, it’s close to it. And in my view that poses the
major danger to the stability of the economy as we proceed. (FOMC, Transcript, 3/20/1979,
pp. 9-10)
Vice Chairman Volcker...And [inflation] clearly remains our problem. In any longer-range or
indeed shorter-range perspective, the inflationary momentum has been increasing. In terms of
economic stability in the future that is what is likely to give us the most problems and create the
biggest recession. And the difficulty in getting out of a recession, if we succeed, is that it conveys
an impression that we are not dealing with inflation. I’m afraid that is the impression that we are
conveying. We talk about gradually decelerating the rate of inflation over a series of years. In
fact, it has been accelerating over a series of years and hasn’t yet shown any signs of reversing.
(FOMC, Transcript, 4/17/1979, p. 16)
Vice Chairman Volcker...I’m impressed by the degree that inflation is now built into thinking
in terms of the business outlook. I’m also impressed—the supporting factor—by the degree with
which capacity problems and backlogs exist...Frank Morris said that we can’t casually assume
the recession will be mild. I suppose we can’t casually assume it, although it looks that way to
me now—if we’re going to have one. But we can’t always be looking at the worst. If we’re going
to balance these risks of inflation and recession we have to run not too scared that the recession
is going to be worse than we expect. So it is a question of bringing about a balance. (FOMC,
Transcript, 5/22/1979, p. 22)
While vice chairman, Volcker expressed skepticism about the ability of economists to make
accurate forecasts.
Vice Chairman Volcker...When I look at the outlook for real GNP, it does seem to me that the
staff forecast of six quarters of approximately 1 percent growth in GNP per quarter is inherently
improbable. I don’t think that has ever happened.
Chairman Miller. Plus or minus 3 percent.
Federal Reserve Bank of St. Louis REVIEW
November/December 2013
493
Lindsey, Orphanides, Rasche
Vice Chairman Volcker. That is precisely the difficulty. The reason they have come up with
this forecast is that one doesn’t know whether the 3 percent error will in fact be plus or minus. I
must say in talking about projection errors that I am much more concerned about the persistent
errors in the projections of the inflation rate than I am about the recent errors in the projections
of the monetary aggregates. The inflation projections have been consistently on the low side. And
I’m not just talking about the staff ’s projections; I think that has been true of most forecasters.
(FOMC, Transcript, 4/17/1979, pp. 15-16)
Vice Chairman Volcker...I’m not inclined to raise the question of whether the staff have overestimated the rate of price increase; I doubt that that’s the case. (FOMC, Transcript, 7/11/1979,
p. 7)
Given his view of the outlook for inflation, despite more hopeful forecasts by others, Volcker
advocated monetary policy tightening in the first part of the year before the policy move in that
direction in late April. In February he first voted in a straw poll against standing pat before grudgingly switching his vote in the end. However, he dissented from that policy stance at both the
March and April meetings.
Vice Chairman Volcker...I think we are at a critical point in the inflation program, with the
tide against us. If we don’t show any response at all, we are giving an unfortunate signal in my
judgment. I believe those concerned about inflation would find no response during this period
almost inexplicable in terms of what we say regarding our worries about inflation...I do think
we need to make some move in recognition of what has been happening on the inflation front.
And I think its good for the stability of the economy in the long run. (FOMC, Transcript,
3/20/1979, pp. 10, 28)
Vice Chairman Volcker...We may be one month closer to a recession than we were last month
and I think we are late [in tightening], but I still am of the view that some greater degree of
restriction would be more appropriate than the reverse [and] more appropriate than standing
still. (FOMC, Transcript, 4/17/1979, p. 16)
His hawkish perspective at the March and April meetings did not, however, stem mainly from
recent rapid money growth—which at that time in fact was running far below expectations.5
Vice Chairman Volcker...I don’t think that {money} target itself, though written in our
records, is written in heaven, given all the uncertainties that we had when we set it...{T}he exact
level of the aggregates isn’t quite as important to me as the movement on the funds rate. I’d like
to make some gesture there immediately. (FOMC, Transcript, 3/20/1979, pp. 28-29)
Vice Chairman Volcker...I sit here listening to all this about the aggregates and it seems to me
that the only reasonable conclusion is not to put much weight on the aggregates. We see relationships that go way out of the range of historical experience. We haven’t any idea of the validity of
the forecast [for the monetary aggregates], I’m afraid, and the combination of those two events
does not make me want to linger over the aggregates. (FOMC, Transcript, 4/17/1979, p. 15)
By the time of the May meeting, though, money growth had become more normal, and he
was ready to upgrade the role of the aggregates in policymaking.
Vice Chairman Volcker...As I thought about what to do, I arrived at the same conclusion that
Steve did up to a point—that maybe for lack of anything better we should go back and look at
the aggregates a bit...I was thinking of widening the range mostly in the downward direction
rather than widening it on the up side. But I do think that’s a reasonable approach as we watch
both the aggregates and the business news in the next six weeks. (FOMC, Transcript, 5/11/1979,
p. 22)
494
November/December 2013
Federal Reserve Bank of St. Louis REVIEW
Centennial Issue
Volcker’s hawkish views were well known outside the Federal Reserve as well as inside at
the time President Carter interviewed him for Federal Reserve chairman in July. In Volcker’s
recollection of the interview, “I told him the Federal Reserve was going to have to be tighter and
that it was very important that its independence be maintained.” Although Volcker thought that
these views might preclude his nomination as chairman, the president proved him wrong despite
the opposition of some of his advisers (Treaster, 2004, pp. 61-62). President Carter’s nomination
of Paul Volcker to replace G. William Miller as chairman of the Federal Reserve Board was
announced on July 25. The exchange value of the dollar steadied on this news, but in a July 27
conference call that was not transcribed, the FOMC voted to raise not the actual funds rate target
but rather the upper limit of its allowable range to 10¾ percent, making a new range of 10½ to
10¾ percent, owing to strong growth in the aggregates (FOMC, 1979b, pp. 1-2).
Volcker’s nomination enjoyed wide support across the political spectrum, and his confirmation hearing on July 30 was relatively uneventful. At the hearing Volcker reiterated his wellpublicized views in favor of curbing inflation and stressed that “if we’re going to have price
stability” it was “indispensable” to bring down the growth of monetary aggregates (U.S. Senate,
1979, p. 12). Volcker took the oath of office on August 6, and he presided over the August 14
FOMC meeting. At that meeting, the FOMC continued its recent turn toward firming. With
two dissents—one in favor of a smaller, and one in favor of a larger, move—the FOMC raised
the funds rate objective from 10⅝ percent or a shade higher to 11 percent. Chairman Volcker’s
thinking can be gleaned from a selection of his comments.
Chairman Volcker...It looks as though we’re in a recession; I suppose we have to consider that
the recession could be worse than the staff ’s projections suggest at this time...When we look at
the other side, I don’t have to talk much about the inflation numbers...And when I look ahead,
nobody is very optimistic about the inflation picture...When I look at the past year or two I
am impressed myself by an intangible: the degree to which inflationary psychology has really
changed...{I}t would be very nice if in some sense we could restore our own credentials and
[the credibility] of economic policy in general on the inflation issue. (FOMC, Transcript,
8/14/1979, pp. 20-22)
He proposed “some gesture” at that meeting, though the time did not seem ripe for a major
move or any procedural change.
Chairman Volcker...{W}e don’t have a lot of room for maneuver and I don’t think we want to
use up all our ammunition right now in a really dramatic action; I don’t see that the exchange
market or anything else really requires that at the moment. Certainly dramatic action would
not be understood without more of a crisis atmosphere than there is at the moment. Ordinarily
I tend to think we ought to keep our ammunition reserved as much as possible for more of a
crisis situation where we have a rather clear public backing for whatever drastic action we take.
(FOMC, Transcript, 8/14/1979, pp. 22-23)
On August 16, the Board voted unanimously to increase the discount rate ½ percentage
point to 10½ percent. In response to continued strong aggregates growth and dollar weakness,
the Desk subsequently raised the funds rate objective in two steps (in accordance with directive
instructions) to 11⅜ percent by the end of August, an operating objective that lasted until the
September 18 FOMC meeting. The Board considered additional requests to raise the discount
rate in late August and early September but appeared deeply divided on the need for such
Federal Reserve Bank of St. Louis REVIEW
November/December 2013
495
Lindsey, Orphanides, Rasche
increases. In late August, the Board voted against such raises. Then, in early September it tabled
multiple requests for additional action, effectively postponing a decision until after the FOMC
meeting scheduled for September 18 (BOG, Minutes, 9/7/1979, p. 4; 9/14/1979, p. 3).
Early in the September 18 meeting, President Roos of the Federal Reserve Bank of St. Louis
raised the question of whether the FOMC’s operating procedures should be reexamined. Chairman Volcker indicated that the Committee’s decision that day should be within the traditional
approach but that the question should be reassessed soon by the Committee.
Mr. Roos...[Given] your statements, which I think are great, that we’re never going to accomplish our ultimate goal until we achieve some discipline in terms of monetary growth, couldn’t
we discuss these issues again? Maybe I am out of order to raise this now, but couldn’t there be a
discussion again of whether or not our traditional policy of targeting on interest rates, in spite
of the possible adverse consequences in terms of money growth, [is appropriate]? Shouldn’t this
be given another look in view of everything you’ve said and in view of the less than happy experience that the FOMC has had over the past years in achieving its goals of stability in terms of
the inflation problem? Shouldn’t we take a look at this in some way?
Chairman Volcker. My feeling would be that you’re not out of order in raising that question,
Mr. Roos. We would be out of order in having an extended discussion of it today, because I don’t
think we’re going to resolve it. I presume that today, for better or worse, we have to couch our
policy in what has become the traditional framework. But I think it is a very relevant question,
which has come up from time to time, and I think we should be exploring it again in the relatively near future. And I would plan to do so. (FOMC, Transcript, 9/18/1979, pp. 13-14)
Later at that FOMC meeting, Chairman Volcker, in laying out the policy choice, again noted
both horns of the existing dilemma.
Chairman Volcker...There is a very strong possibility of recession on the one side. We’ve had
that possibility for almost six months now and we still have the unemployment rate at a level
that some consider to be the natural rate. I don’t know whether it is or it isn’t, but we had a lot
of discussion earlier, which may be reflected in some of the comments about labor markets still
being fairly tight. And, obviously, we have inflation as strong as ever. We have a difficult timing
problem. Difficult or not we have a timing problem if the business outlook develops more or
less as projected, in that we don’t have a lot of flexibility—at least flexibility in a tightening direction—in terms of what we can do in the midst of a real downturn...But we are in a rather crucial
period in terms of how much the probably deteriorating inflationary expectations now get built
into the wage structure...I also share the view that has been quite widely expressed that we have
to show some resistance to the growth in money. (FOMC, Transcript, 9/18/1979, pp. 33-34)
He recommended only limited further tightening.
Chairman Volcker...As I listened, among the voting members of the Committee at least, I think
there was a majority desire—but clearly not unanimous—to make a little move on the federal
funds rate. So I would propose 11½ percent on that at this point. I am not particularly eager to
make a major move now or in the foreseeable future, so I would suggest that we put a band
around that of 11¼ to 11¾ percent, which ought to [result in a] reconsideration before a very
major step on the funds rate. (FOMC, Transcript, 9/18/1979, p. 35)
The vote elicited eight assents but four dissents; the dissents included Governor Rice on the
dovish side, but three of them came from hawks—Presidents Balles and Black and Governor
Coldwell—who were disappointed at the lack of sufficiently forceful action. After the conclusion
496
November/December 2013
Federal Reserve Bank of St. Louis REVIEW
Centennial Issue
of the FOMC meeting, the Board met to consider the pending requests for raising the discount
rate. The Board continued to be divided on the desirability of such action. Members supporting
the increase pointed to the virulence of inflation and inflationary expectations, while members
opposing the action emphasized the weakening in economic activity and the lagged effects of
monetary policy. In the end, the Board split nearly evenly in approving a ½-percentage-point
discount rate hike to 11 percent: The vote was four to three, with the dissenting votes all on the
dovish side—Governors Partee, Rice, and Teeters.
As usual, the vote on the discount rate, with the three dissents toward more dovish policy,
became known right away after the announcement of the discount rate change. By contrast,
neither the FOMC’s tightening action that morning nor the hawkish sentiment reflected in the
three dissents in favor of further tightening was released immediately. Without this information,
the dovish dissents on the discount rate had a dramatic and arguably misleading effect on perceptions regarding the policy intentions of the FOMC. The Board action engendered the perception that the Federal Reserve’s resistance to inflationary forces would be insufficient and
discomfited financial markets. The press interpreted the vote thusly:
Many money market analysts have been expecting the FOMC to seek to tighten credit again in
an effort to slow down sharp increases in the money supply...However, the split vote, with its
clear signal that from the Fed’s own point of view interest rates are at or close to their peak for
this business cycle, might forestall any more increases in market interest rates. (Berry, 1979, A1)
This division indicates that Mr. Volcker’s drive for a restrictive monetary policy may encounter
increasing opposition within the seven-member board. (Wall Street Journal [WSJ], 1979b, p. 2)
[T]he vote left uncertain whether Paul A. Volcker, who became Federal Reserve chairman early
in August, could continue to command a majority for his high-rate policies. The split was seen
as indicating a fundamental division within the board over whether inflation remains a more
pressing problem than recession...
“A 4-3 split is significant because it means Volcker will have to sit harder on the liberal governors,” Jeffrey A. Nichols, vice president and chief economist of the Argus Research Corporation,
said. “The Chairman will have to be tough to keep the other members under control.”...
One banker said she thought the failure of the board yesterday to cite inflation or the growth
of the money supply, but merely to note technical factors, could indicate a compromise with
governors who were becoming more concerned about recession than inflation. “It might mean
we have the beginnings of a dovish voting group,” she added. (Bennett, 1979, p. A1)
Some dealers reasoned that the Federal Reserve Board’s 4-to-3 split vote on the discount rate
increase meant the central bank would have difficulty in making further moves to restrict the
growth of money and credit...
“The Reserve Board vote,” one municipal bond dealer said, “makes me think that this is as
much of a push toward higher rates as we’re going to get for a while. I [don’t] think that 4-to-3
vote sat very well with a lot of traders today.” (Allen, 1979, p. D9)
The 4-to-3 split gave rise to speculation that the Federal Reserve was unlikely to drive interest
rates still higher. (Cowan, 1979, p. 1)
The relatively small increase in the funds target reflects “a growing split within the Fed’s policymaking circle,” according to David Jones, an economist for Aubrey G. Lanston & Co. He reasoned that with the economy losing steam some Fed officials want a pause in credit tightening
while others contend that further moves are necessary to battle inflation. (WSJ, 1979e, p. 5)
Federal Reserve Bank of St. Louis REVIEW
November/December 2013
497
Lindsey, Orphanides, Rasche
Figure 4
Commodity Futures Prices
Gold
Silver
$ U.S. Per Ounce
500
Daily
Aug. 14
$ U.S. Per Ounce
2,000
Daily
Aug. 14
1,800
Sept. 18
Oct. 6
450
Sept. 18
Oct. 6
1,600
400
1,400
350
1,200
1,000
300
Aug.
Aug.
Oct.
Sept.
1979
Copper
Platinum
$ U.S. Per Ounce
130
Daily
Aug. 14
120
$ U.S. Per Ounce
650
Daily Aug. 14
Sept. 18
Oct. 6
Sept.
1979
Sept. 18
Oct.
Oct. 6
600
550
110
500
100
450
90
400
80
Aug.
Sept.
1979
Oct.
Aug.
Sept.
1979
Oct.
NOTE: For each day, the graphs show the opening price and high/low trading range during the day. Vertical lines denote FOMC meetings.
The events of September 18 had a swift destabilizing effect on markets that set the tone for
developments over the following three weeks. Commodity markets, in particular, became
extremely volatile, alarming policymakers. Developments in commodity markets during this
period are illustrated in Figure 4, which shows the daily futures prices of the December 1979
contracts for gold, silver, and copper and the January 1980 contract for platinum. The vertical
lines in each panel indicate the dates of FOMC meetings. The continuous line designates the
opening price each day, while the high-low lines denote the intraday range of price fluctuation.
Gold and silver futures prices rose steadily between the August and September FOMC meeting
dates, but with the exception of a few days, the intraday volatility was little changed from earlier
in the summer. Copper futures were stable during this period, and, though platinum prices rose,
they merely returned to mid-year levels.
498
November/December 2013
Federal Reserve Bank of St. Louis REVIEW
Centennial Issue
The behavior of prices in these markets changed dramatically in the days after the discountrate announcement. Gold and silver prices continued moving up, and intraday volatility increased
substantially. Copper and platinum futures prices rose rapidly, also with substantial intraday
volatility. Prices on all four futures contracts reached a peak on October 2 and retreated sharply
for the next several days.
The price developments in these markets were noted regularly in the press. A sample of this
commentary, which uniformly interpreted these developments as evidence of hedging against
inflation, follows.
For gold’s rise, analysts had been citing the metal’s traditional allure during times of inflation
and general global unease. (WSJ, 1979a, p. 3)
With a leap that would have been dismissed before as inconceivable, the price of gold soared a
record $24 an ounce in London, to another high of $375.75, and then jumped an additional
$6.25 in later dealings in New York.
Although he [a Treasury official] said he didn’t believe gold’s surge was “directed particularly
against the dollar,” he said the jump was “disturbing” and could cause a “widespread psychological reaction...a lack of confidence in our ability to turn inflation around.” (WSJ, 1979c, p. 8)
Mr. Miller told the National Conference of State Legislatures that there has been a “speculative
trend” in the gold market as people bought gold as an inflationary hedge...
Another Treasury official called the current gold rush “a symptom of growing concern about
world-wide inflation.” Lisle Widman, the Treasury’s deputy assistant secretary for international
monetary affairs, added that “the message we would draw is that governments around the globe
need to redouble efforts to curb inflation.”(WSJ, 1979d, p. 2)
In the commodity markets, nervous speculators sent futures prices through wild gyrations. At
first, prices rose sharply as the recent bout of gold and silver fever spread to markets for other raw
materials. Gold, silver, copper, platinum and sugar all rose to new highs in early dealings, presumably because inflation-wary speculators continued to dump dollars in favor of commodities...
But then came the rumors that the U.S. might be planning a major new dollar-support program. On the theory that fighting inflation to save the dollar might depress commodity prices,
speculators began selling, and many futures prices skidded the maximum permitted in a single
day of trading. By the end of the day, however, most prices recovered somewhat when the rumors
hadn’t been substantiated, and many traders admitted to considerable confusion about the day’s
developments. (WSJ, 1979f, p. 1)
A few days after the discount-rate vote, Governor Partee spoke to the Money Marketeers in
New York. Their harsh questions converted him on the spot from a dove to a hawk (Greider, 1987,
p. 85).
As September drew to a close, the crisis that Chairman Volcker spoke of at the August FOMC
meeting evidently had arrived, and the need for a dramatic monetary policy announcement had
become compelling. The Chairman became increasingly convinced that such action should
include a change in operating procedures deemphasizing the federal funds rate in favor of
reserves as an operating instrument. He asked Stephen Axilrod, Economist for the FOMC, and
Peter Sternlight, Manager for Domestic Operations, System Open Market Account, to prepare a
background memorandum for the FOMC outlining the general features of such a proposed new
approach. He also discussed changing the operating procedures with the other members of the
Federal Reserve Bank of St. Louis REVIEW
November/December 2013
499
Lindsey, Orphanides, Rasche
Board to garner their support early on (Greider, 1987, pp. 105-118; Volcker and Gyohten, 1992,
pp. 167; Treaster, 2004, p. 150; FOMC, Transcript, 10/5/1979, p. 1).
In his discussions with the Board members, Fred Schultz, the Board’s vice chairman, lined
up foursquare behind the Chairman, as would usually be the case in decisions to come, in this
instance in his support for the Chairman’s call for dramatic monetary-policy action. The three
Board members who had voted against the discount rate hike, Teeters, Rice, and Partee, also
supported the change. As will be discussed in more detail below, they liked the automaticity of
the reserves-based technique in that the FOMC did not choose, and thus could not be identified as having chosen, the specific level of the funds rate. The two hawks, Wallich and Coldwell,
were philosophically opposed to money and reserve targeting as unreliable and as removing too
much central bank judgment from the monetary policy process, but they were willing to go along
with it if necessary to get FOMC support for a substantially tighter policy stance. According to
Greider,
Wallich did not argue much. “I was not sure people would do it my way,” he said. “It was probably
wise to use a method that produced a consensus for tightening.” (Greider, 1987, p. 113)
On September 29, Chairman Volcker left for the annual International Monetary Fund (IMF)
meeting, which was in Belgrade that year.6 On the plane flight to Europe, the Chairman took
the opportunity to brief two top administration officials, G. William Miller, who was now
Secretary of the Treasury, and Charles Schultze, chairman of the Council of Economic Advisers.
They were not enthusiastic about the idea of new procedures, and in coming days they made
their solidifying views known to Volcker. Moreover, in their subsequent conversations with
President Jimmy Carter, the president may have voiced similar concerns to them. But Chairman
Volcker considered it significant that the president never directly expressed this disapproval to
him in person or otherwise (Volcker and Gyohten, 1992, pp. 168-69).
On his trip abroad, Chairman Volcker also sought the counsel of various trusted foreign
leaders and central bankers, including Germany’s Helmut Schmidt and Otmar Emminger. Their
comments only reinforced his intention to move ahead. When his participation was no longer
required at the IMF meetings, he returned early to the United States (Volcker and Gyohten, 1992,
p. 168).
Chairman Volcker arrived in Washington on Tuesday, October 2, with his ears still resonating with strongly stated European recommendations for stern action to stem severe dollar weakness on exchange markets. His unexpectedly early return fueled market rumors that action dealing
with the crisis might be imminent. This had a stabilizing effect on commodities markets, with
futures markets opening lower on October 3, retracing some of their sharp increases of the previous several days (see Figure 4).
The next regularly scheduled meeting of the FOMC was to take place on October 16, 1979,
two weeks after Volcker’s return from Europe. However, likely in light of the urgency of the situation after September 18, the Chairman instead decided to convene a special FOMC meeting
earlier in the month. The special meeting, scheduled in secret and on very short notice, was to
take place on Saturday, October 6, in Washington.
Few new governmental data were released in the three weeks after September 18 that could
have provoked a sense of urgency about significant policy action. Table 1, reproduced from the
500
November/December 2013
Federal Reserve Bank of St. Louis REVIEW
Centennial Issue
Table 1
SOURCE: October 12, 1979, Greenbook.
Federal Reserve Bank of St. Louis REVIEW
November/December 2013
501
Lindsey, Orphanides, Rasche
Greenbook from October 12, 1979, shows the dating of various statistical releases tracked by the
staff between September 18 and October 5. The only data published after that starting date but
before Volcker left for Belgrade were for the consumer price index (CPI) and housing starts in
August. To be sure, the annualized one-month core CPI inflation rate in August exceeded 12 percent, up substantially from the 8.7 percent July core CPI inflation rate available at the September
FOMC meeting. But this information, while unpleasant, did not seem to be the source of the
alarm, as will be seen from Chairman Volcker’s interpretation of these figures on October 6.
On the morning of Thursday, October 4, two days before the planned Saturday meeting,
the Board met in its Special Library to discuss the possible monetary policy actions under consideration. According to the Minutes of the meeting:
[O]ne member of the Board referred to the outburst of speculative activity in the gold market,
which appeared to be spilling over into other commodity markets as well, and to the very sensitive conditions in domestic financial and dollar exchange markets. He also noted that inflationary sentiment appeared to be intensifying as data on price increases continued to worsen.
Against this background, the staff had been directed to prepare memoranda on a package of
possible actions designed to show convincingly the Federal Reserve’s resolve to contain monetary and credit expansion in the U.S., to help curb emerging speculative excesses, and thereby
to dampen inflationary forces and lend support to the dollar in foreign exchange markets. Such
a package might include actions on reserve requirements and the discount rate; in addition, the
staff had been asked to analyze the implications of a possible shift in Federal Open Market Committee procedures, whereby the Desk, in its day-to-day operations, would operate more directly
on a bank reserves, rather than a Federal funds rate, target. (BOG, Minutes, 10/4/1979, pp. 1-2)
The Minutes indicate that “Board members agreed on the seriousness of the situation and
on the need for action” but postponed taking decisions on reserve requirements and the discount
rate until Saturday, when the special FOMC meeting was to be held (BOG, Minutes, 10/4/1979,
pp. 2-4).
That same day, the background memorandum on the proposed new operating procedures
that Stephen Axilrod and Peter Sternlight were preparing at Chairman Volcker’s request was
finalized and sent electronically to the FOMC. The Axilrod and Sternlight memorandum envisioned that the FOMC would specify desired short-run growth rates for M1 and other monetary
aggregates. The staff would then construct the associated paths for total reserves and the monetary base. The memorandum also suggested another point at which an FOMC decision would
be a crucial aspect of the newly structured operations.
A method for setting the level of nonborrowed reserves would be to take the average level of
borrowing in recent weeks and subtract them from total reserves. Or the Committee could take
a different level of borrowing—either higher or lower—depending in part on whether it wishes
to tilt money market conditions toward tightness or ease in the period ahead. Whether money
market interest rates would tend to rise, or rise more than they otherwise would, then depends
on whether the demand for the total monetary base or total reserves were strong relative to the
FOMC’s path. If strong, the funds rate and the level of member banks borrowing would tend to
rise as the Desk adhered to the initial path level {of} nonborrowed reserves. Conversely, if
demands were weak, the funds rate, and the level of member bank borrowing, would tend to
decline. (Axilrod and Sternlight, 1979, p. 7)
502
November/December 2013
Federal Reserve Bank of St. Louis REVIEW
Centennial Issue
The FOMC held a last-minute information-sharing conference call on October 5.
Chairman Volcker...You will have very shortly, if you don’t already, a memorandum that Steve
Axilrod and Peter Sternlight prepared describing a possible approach that involves leaning more
heavily on the aggregates in the period immediately ahead. And the complement of that is leaning less heavily on the federal funds rate in terms of immediate policy objectives. We have had
some considerable discussion of that over the past couple of weeks here and that memorandum
attempts to distill some of the thinking. I want to discuss tomorrow whether to adopt that
approach, not as a permanent [decision] at this stage, but as an approach for between now and
the end of the year, roughly, in any event. (FOMC, Transcript, 10/5/1979, p. 1)
He also referred to the unstable conditions in commodities markets.
Chairman Volcker. The discussions abroad were very difficult in a number of respects. The
feeling of confidence is not high, I should say, in a number of directions and that increases the
difficulty of restoring a sense of stability. One of the alarming things earlier, to me at least, was
the sensitivity and responsiveness of some of the commodity markets outside of gold and silver
to what was going on. There were some very sharp increases in prices of copper and other metals
at the end of last week and at the beginning of this week, a development that has since subsided
somewhat with the improvement in the gold market and the exchange market. But, quite clearly,
we are in a very sensitive period. (FOMC, Transcript, 10/5/1979, p. 4)
The momentous special meeting convened at 10:10 a.m. on Saturday. Chairman Volcker
framed the issues.
Chairman Volcker...We wouldn’t be here today if we didn’t have a problem with the state of the
markets, whether international or domestic. They were pretty feverish last week—or beginning
in the previous week, really. Beginning about 2 weeks ago and carrying over into the early part
of what is still this week, the foreign exchange market was in a situation that was clearly not
amenable for very long to such techniques as intervention. The markets have turned around
some in the past few days, as you know. I think that is almost entirely explicable by the fact that
at about the time I returned from Belgrade Treasury officials and others were making some
statements that left hanging the possibility of some kind of a package, so the foreign exchange
dealers have retreated to the sidelines...
In terms of the economy...my own concerns about the risks of the economy falling off the
table, though they have not evaporated, have diminished a bit...On the price front, expectations
have certainly gotten worse rather than better...I certainly conclude from all this that we can’t
walk away today without a program that is strong in fact and perceived as strong in terms of
dealing with the situation...{W}e are not dealing with a stable psychological or stable expectational situation by any means. And on the inflation front we’re probably losing ground. In an
expectational sense, I think we certainly are, and that is being reflected in extremely volatile
financial markets...{Regarding} the commodities issue{, b}eginning a little more than a week
ago, late in the previous week when the gold market was gyrating, there was some very clear evidence that this psychology was getting into the metals markets in particular in a very forceful
way and maybe in the grains markets very temporarily...The psychology in the foreign markets
is the same as the psychology at home; it is reflected in the metals markets. It is the inflationary
psychology or whatever. (FOMC, Transcript, 10/6/1979, pp. 4-6, 12, 15)
Chairman Volcker argued, however, that overall inflation data were not alarming as yet.
Chairman Volcker...Even though the price news is bad, it does not in my judgment as yet reflect
a spreading of the whole inflationary force into areas outside of energy. We had a fluctuation in
food [prices] last month, but that [component of the price index] goes up and down. If we look
Federal Reserve Bank of St. Louis REVIEW
November/December 2013
503
Lindsey, Orphanides, Rasche
at the wage trend, so far as we know—with the exception of the General Motors settlement—
we haven’t had a real breakout yet. But we’re dealing with a situation where that’s an imminent
danger on the one side as is the possibility of a recession on the other side. (FOMC, Transcript,
10/6/1979, p. 5)
Chairman Volcker then laid out the specific options.
Chairman Volcker...Now, when it comes to our action here, I think there are broadly two possibilities. One is taking measures of what might be thought of as the traditional type. That would
include a discount rate move on the one side and so far as this Committee is concerned a significant increase in the federal funds rate— putting those moves together. The Board will be considering some reserve requirement changes later today. Let’s assume that the package would
include that...
The other possibility is a change in the emphasis of our operations as outlined in the memorandum that was distributed, which I hope you’ve all had a chance to read. That involves managing Desk operations from week to week essentially, with a greater effort to bring about a reserve
path that will in turn achieve a money supply target—which we have to discuss—recognizing
that that would require a wider range for the federal funds rate and would involve a more active
management of the discount rate. And of course the question of reserve requirements and the
discount rate change at this point are relevant in that context too. (FOMC, Transcript, 10/6/1979,
pp. 7-8)
In presenting the pros and cons of each option, Chairman Volcker first mentioned that
changing operating procedures had occurred to him some time ago.
Chairman Volcker...I must say that the thought of changing our method of operations germinated—in my mind at least—before the market psychology or nervousness reached the extreme
stage it reached over the past week or so. My feeling was that putting even more emphasis on
meeting the money supply targets and changing operating techniques [in order to do so] and
thereby changing psychology a bit, we might actually get more bang for the buck...I overstate it,
but the traditional method of making small moves has in some sense, though not completely,
run out of psychological gas. (FOMC, Transcript, 10/6/1979, p. 8)
He made it clear that the choice of the initial borrowing assumption, in principle, should be
based on the same predicted level of the federal funds rate (converted to a spread over the discount rate) that was associated with the projection of near-term M1 growth matching the FOMC’s
target path for that aggregate.
Chairman Volcker...Suppose we happen to put a lot of weight on the current projection of the
money supply and pick figures that would closely coincide with that. We would then provide,
making some assumption on the level of borrowing that seemed to be consistent with the level
of interest rates that presumably laid behind the projection of the money supply in the first
place—we can’t avoid interest rate assumptions the way these things are done—nonborrowed
reserves along that path. If the money supply actually grew faster, borrowings would go up and
presumably interest rates would go up; if the reverse happened, borrowings would go down and
interest rates would go down. (FOMC, Transcript, 10/6/1979, p. 25)
(Instead, the procedure for giving the FOMC alternative initial borrowing assumptions that
was put forth in the aforementioned Axilrod-Sternlight memorandum was in fact followed in
practice for a little longer than a year.)
Chairman Volcker said that he could live with either option but again stated that in his mind
a decision to adopt the second one would be only temporary.
504
November/December 2013
Federal Reserve Bank of St. Louis REVIEW
Centennial Issue
Chairman Volcker...I am prepared, within the broad parameters, to go with whichever way the
consensus wants to go so long as the program is strong, and if we adopt the new approach so
long as we are not locked into it indefinitely. If we adopt the new approach, I’d consider it something that we adopted that seems particularly suitable to the situation at this time. (FOMC,
Transcript, 10/6/1979, p. 10)
The Committee discussed whether a change in procedures would lock it in for a considerable
period.
Mr. Eastburn...There’s a credibility problem if we launch this and stop and go with it. So I really
think we are committed to this if we go [forward].
Chairman Volcker. Well, I don’t want to accept that. I don’t think we can make that decision
now. If we [change our operating technique], I do accept the fact that to some degree we have
prejudiced the discussion we will have at the end of the year. We will have to have a reason then
to move back to the traditional method. But I don’t think we can really make that decision now,
nor should we. Nor do I think this commits us that fully, though it prejudices to some degree
what we would do next year. (FOMC, Transcript, 10/6/1979, p. 15)
Chairman Volcker...There’s an immediate advantage in the publicity {regarding the change in
technique}; there is a disadvantage not very far down the road if people read this as a commitment and in fact we are not going to be able to live up to that commitment. (FOMC, Transcript,
10/6/1979, p. 27)
He later noted he preferred that such a decision be reconsidered around year-end, which
arose from his sense that money demand historically had been plagued by institutional innovation and hence instability.
Chairman Volcker...That’s the [reason] I’m not willing to make a judgment at this point as to the
long-run desirability of this technique through thick and thin and in all possible circumstances.
So, I would remind you that because of the particular circumstances I am thinking of using
this technique for the [coming] 3- or 4-month period. This is a time when it may be particularly
important to our credibility and to the economy and to psychology and everything else that we
provide ourselves with greater assurance that we will get a handle on the money supply. (FOMC,
Transcript, 10/6/1979, p. 28)
In the course of Committee deliberation, President Roos of the Federal Reserve Bank of
St. Louis presented only a limited statement.
Mr. Roos. Well, Mr. Chairman, I assume that my credibility with you and my colleagues would
be severely jeopardized if I came out flatly in opposition to this proposal! [Laughter] I also was
told by my father to keep my mouth shut when things are going well. So all I’ll say is briefly:
God bless you for doing this! [Laughter] (FOMC, Transcript, 10/6/1979, p. 24)
After Committee discussion, a straw poll was conducted of all the governors and presidents.
Staying with the traditional method was preferred by five of those present (FOMC Transcript,
10/6/1979, p. 50). However, a majority preferred switching to the new technique, and the final
official vote was unanimous.
Immediately following the FOMC meeting, at 1:30 p.m., the Board met to consider discount
rate and reserve requirement actions. The Board unanimously approved a 1-percentage-point
increase in the basic discount rate, a comparable rise in subsidiary rates, and an 8 percent marginal reserve requirement on managed liabilities (BOG, Minutes, 10/6/1979, pp. 1-7).
Federal Reserve Bank of St. Louis REVIEW
November/December 2013
505
Lindsey, Orphanides, Rasche
The Board authorized a press release describing all of these actions. The press release stated
prominently that the Committee’s and the Board’s respective votes on the actions taken were
unanimous. In characterizing the essence of the new technique, the release noted its temporary
rationale.
Actions taken are:...3. A change in the method used to conduct monetary policy to support the
objective of containing growth in the monetary aggregates over the remainder of this year within
the ranges previously adopted by the Federal Reserve. These ranges are consistent with moderate
growth in the aggregates over the months ahead. This action involves placing greater emphasis
in day-to-day operations on the supply of bank reserves and less emphasis on confining shortterm fluctuations in the federal funds rate. (BOG, 1979d, p. 1)
Then a press conference was scheduled for 6:00 p.m.
Mr. Volcker. I think in general you know the background of these actions; the inflation rate has
been moving at an excessive rate and the fact that inflation and the anticipations of inflation
have been unsettling to markets both at home and abroad. That unsettlement in itself and its
reflection in some commodity markets is, I think, contrary to the basic objective of an orderly
development of economic activity. (BOG, 1979e, p. 1)
He indicated that the purpose of the new procedures was to hit the money growth ranges
for the current year, but any sense that the FOMC had adopted the techniques only provisionally
was lost on everyone:
Mr. Volcker. I would emphasize that the broad thrust is to bring monetary expansion and credit
expansion within the ranges that were established by the Federal Reserve a year ago. (BOG,
1979e, p. 2)
Finally, Chairman Volcker was asked about the real-side impact of the new initiatives.
Question. But in immediate terms does it have an effect that will tend to slow down economic
growth that is already too wishy-washy in this country?
Mr. Volcker. Well, you get varying opinions about that. I don’t think it will have important
effects in that connection. I would be optimistic in the results of these actions. But we’re in an
area dealing with economic events that are not fully predictable. I think the main thing to say
about the economy right now is that it is somewhat stronger than anticipated. The outlook
continues to be, in a general way, that some inventory adjustment may be in prospect. I think
the best indications that I have now in an uncertain world is that it can be accomplished reasonably smoothly. (BOG, 1979e, p. 8)
At a White House press conference the same day, Jody Powell read the following official
presidential statement:
The administration believes that the actions decided upon today by the Federal Reserve Board
will help reduce inflationary expectations, contribute to a stronger U.S. dollar abroad, and curb
unhealthy speculations in commodity markets.
Recent high rates of inflation, led by surging oil prices, other economic data, as well as developments in commodity and foreign exchange markets, have reinforced the administration’s
conviction that fighting inflation remains the Nation’s number one economic priority.
The administration will continue to emphasize a policy of budgetary restraint. Enactment of
effective national energy legislation to reduce dependence on foreign oil is vital to long-term
success in this effort.
506
November/December 2013
Federal Reserve Bank of St. Louis REVIEW
Centennial Issue
The administration believes that success in reducing inflationary pressures will lead in due
course both to lower rates of price increases and to lower interest rates. (Carter, 1980, p. 1835)
After the initial events on October 6, Chairman Volcker made several additional public
appearances to explain the various actions. In a speech to the American Bankers Association
(ABA) on the morning of Tuesday, October 9, he provided an overview.
Those measures were specifically designed to provide added assurance that the money supply
and bank credit expansion would be kept under firm control. There will be one seemingly technical, but potentially significant, change in procedure in conducting open market operations.
More emphasis will be placed on limiting the provision of reserves to the banking system—
which ultimately limits the supply of deposits and money—to keep monetary growth within
our established targets for this year. We have raised the discount rate—and will manage it more
flexibly—so that restraint on bank reserves will not be offset by excessive borrowing from the
Federal Reserve Banks. We have placed a special marginal reserve requirement of 8 percent on
increases in “managed liabilities” of larger banks (including U.S. agencies and branches of foreign
banks) because that source of funds has financed much of the recent buildup in credit expansion.
That requirement, admittedly cumbersome by its nature, will be maintained so long as credit
expansion is excessive...
As the rate of increase in energy prices subsides—as it should in coming months—the inflation rate as a whole should also decline appreciably. Looked at another way, the immediate challenge is to avoid imbedding the current rate of inflation in expectations and wage and pricing
decisions, before the current bulge in prices subsides. That is not an unrealistic objective, but it
is one that will require discipline over the months ahead. (Volcker, 1979a, pp. 3, 8)
In that speech, he added,
Attempts to pin all blame for inflation on factors outside our control would only doom our
efforts to futility. (Volcker, 1979a, p. 8)
That Tuesday morning as well, the WSJ ran a story that included this paragraph:
Among those who are skeptical that the Fed will really stick to an aggregate target is Alan
Greenspan, president of Townsend-Greenspan & Co., a New York economics consultant. Mr.
Greenspan, who served as chief economic advisor to Presidents Nixon and Ford, questions
whether, if unemployment begins to climb significantly, monetary authorities will have the fortitude to “stick to the new policy.” 7 (WSJ, 1979g, pp. 1, 6)
The WSJ published a story the following day, Wednesday, October 10, that included more
information: Additional meetings had been held on October 9.
Officials of the Federal Reserve Bank of New York held separate meetings yesterday with
reporters and securities dealers in an effort to clear up some of the confusion surrounding
details of the Federal Reserve’s anti-inflation techniques announced Saturday.
Peter D. Sternlight, Senior Vice President of the New York Fed, said he doesn’t know all of
the answers yet. “We’re in the midst of a learning process ourselves,” he said. “We have some
objectives but don’t have procedures at this stage...”
Mr. Sternlight also said the Fed doesn’t plan to be “rigid or mechanistic” in pursuit of bankreserve targets. “This may cause some die-hard monetarists to subdue their elation at our change
in approach and recall their congratulatory messages,” he said...
When a reporter asked what rates the public should watch for clues to Fed thinking, Mr.
Sternlight replied: “I’m not sure I have a ready substitute to proffer at this point.” He emphasized that “we’re still very much experimental” at this stage.
Federal Reserve Bank of St. Louis REVIEW
November/December 2013
507
Lindsey, Orphanides, Rasche
Mr. Sternlight said one key figure the Fed would pay attention to is “nonborrowed reserves.”
But he emphasized that the Fed won’t rely exclusively on this and plans to remain flexible in its
approach. (WSJ, 1979h, p. 3)
Besides not reassuring the dealers (Melton, 1985, p. 49), this briefing content was received
with a certain displeasure at the Board in Washington, as it seemed to undermine both the
Federal Reserve’s commitment to the new approach and the care with which the new procedures
had been thought-through in advance (David Lindsey’s recollection).
On Wednesday, the day that the story above was published, “a Fed official,” perhaps Chairman Volcker, spoke to the WSJ, which published the following story:
As markets gyrated in the uncertainty following the Federal Reserve Board’s weekend policy
switch, a Fed official warned that the central bank will continue to be unpredictable.
“Anybody looking for a rule of thumb is going to be frustrated,” the official said in an interview that sketched a picture of a more flexible—and probably tougher—Fed.
“There are still going to have to be policy judgments made,” the official said, indicating the
central bank “isn’t going to trap itself by following any rule.” He said the Fed will try to steer
between the “two extremes” of its old practice of inching the federal funds rate up and down
and “letting the funds rate go anyplace forever...”
The Reserve Board official observed that the markets were “scrambling” for clues to get a
“more definite” picture of the Reserve Board’s future behavior. But he added “There isn’t any
sense in scrambling. It doesn’t exist. We changed the procedure. What the limits are going to be
aren’t clear yet.” (Conderacci, 1979, p. 3)
The WSJ reported that reactions among monetarists varied widely. Some were jubilant.
Overcast skies here yesterday did little to dampen the spirits of Laurence K. Roos...
Although the bank was closed because of Columbus Day, Mr. Roos was in his office in downtown St. Louis, and he was beaming. “Except for the unfortunate coincidence of the holiday,
champagne and beer would be flowing in the aisles here,” he says with a broad smile. (Garino,
1979, p. 6)
But feelings of euphoria did not extend to monetarists in academia.
As more details of the Fed’s program emerge from talks with Fed officials, some financial
experts believe the Fed will continue to encounter difficulties trying to rein in the growth of
the money supply...
Nevertheless, Fed officials say they believe they can enforce and execute their program
announced Saturday evening. They acknowledge, though, that some aspects are so new that
they don’t have all the details worked out yet...
Separately, some economists were disheartened by remarks made by Peter D. Sternlight...that
“we don’t plan to be rigid or mechanistic” in pursuit of bank reserve targets and will continue
looking at many other factors.
That worries Allan H. Meltzer, an economics professor at Carnegie-Mellon University. He
says that the Fed may try to fine-tune more items than it has the power to do and that the money
supply may get out of control. He urges the Fed to focus on the “monetary base”...“I didn’t send
them a congratulatory telegram,” he says. “I’m going to hold my breath and hope they don’t
screw it up.” (Herman, 1979, p. 6)
Another story continued in the same vein.
Together with Allan H. Meltzer...Professor [Karl] Brunner six years ago set up the Shadow
Open Market Committee, a group...that meets twice a year to appraise the work of the Fed’s
key policymaking group. The verdict more often than not has been unfavorable.
508
November/December 2013
Federal Reserve Bank of St. Louis REVIEW
Centennial Issue
Prof. Brunner up to now sees no reason to change...
Politics aside, monetarists question whether the Federal Reserve has chosen the best operating technique...
According to the Federal Reserve plan, estimates for nonborrowed reserves will largely
determine what the Fed does as it tries to hit its desired monetary growth rate. Prof. Brunner
wonders why the system does not simplify its task by focusing solely on the monetary base.
Statistical studies, he says, have shown that the relationship between the base and the gross
national product has been smooth and predictable since World War II. Prof. Brunner is quick
to admit that Mr. Volcker sounds much better than some of his immediate predecessors. The
new chairman has been much more willing to concede that the Fed deserves much of the blame
for the existing inflation. He stresses that the important need now is not just to articulate a new
policy but to stick with it...
But monetarists have been burned so often that for now they will withhold their cheers.
Securities markets seem similarly skeptical that the Fed finally is determined to stop inflation...
(Clark, 1979, p. 22)
To further explain the FOMC’s actions, Chairman Volcker appeared on the MacNeil-Lehrer
News Hour on October 10. His first comment reacted to the earlier view of experts that, as a
newly appointed Federal Reserve Chairman, he wouldn’t make any radical changes.
Paul Volcker. Well, I don’t know that these are radical changes in Federal Reserve policy in a
very fundamental sense. We want to deal with this problem of inflation, and I think that intention was perhaps reinforced in the public mind by the actions we took on Saturday; but in a very
basic sense the policy has been there and we intend to carry it out. (MacNeil-Lehrer News Hour,
1979, p. 1)
Commenting on the market reaction, he went on to underscore the point that the Federal
Reserve was determined to bring down both actual and expected inflation.
Paul Volcker. I think the point may be that we captured their attention...and I think that’s constructive in a sense, because there’ve been a lot of doubts, a lot of anxiety that this inflation was
going to get out of control. And it’s not going to get out control if we do our job...[A] lot of people were skeptical whether we could deal with it. I hope they’re less skeptical now than they were
before... (MacNeil-Lehrer News Hour, 1979, p. 2)
He stressed the long-run rather than the short-run effect on real economic activity.
Paul Volcker. And this is the kind of circumstance which leads to concern about recession;
and I share that concern. But...[i]f inflation got out of hand, it’s quite clear that that would be
the greatest threat to the continuing growth of the economy, to the productivity of the economy,
to the investment environment, and ultimately to employment...Now, I’m not saying that unemployment will not rise. I am saying the greater threat over a period of time would come from
failing to deal with inflation rather than efforts to deal with it. (MacNeil-Lehrer News Hour, 1979,
pp. 6-7)
In a subsequent appearance on Issues and Answers on October 29, he spoke further.
Mr. Volcker. We are in a very difficult economic situation, but I would not, in terms of a possible
recession, which has been discussed for months, trace that to our particular actions. The situation we had was rising inflation, speculation, a weak dollar. (ABC News’ Issues and Answers,
1979, p. 2)
On October 17, before the Joint Economic Committee, Chairman Volcker dealt in more detail
with the effect on public attitudes of the “serious inflationary environment we are now facing.”
Federal Reserve Bank of St. Louis REVIEW
November/December 2013
509
Lindsey, Orphanides, Rasche
An entire generation of young adults has grown up since the mid-1960s knowing only inflation,
indeed an inflation that has seemed to accelerate inexorably. In the circumstances, it is hardly
surprising that many citizens have begun to wonder whether it is realistic to anticipate a return
to general price stability, and have begun to change their behavior accordingly. Inflation feeds
in part on itself. So part of the job of returning to a more stable and more productive economy
must be to break the grip of inflationary expectations.
We have recently seen clear evidence of the pervasive influence of inflationary expectations
on the orderly functioning of financial and commodity markets, and on the value of the dollar
internationally. Over a longer period of time, the uncertainties and distortions inherent in inflation have a debilitating influence on investment, productivity and growth. In the circumstances,
the overwhelming feeling in the nation—that we must come to grips with the problem—reflects
the common sense of the American people. At the same time, we have to recognize that, after
more than four years of expansion, there are widespread anticipations of inventory adjustments
and a downturn in economic activity. The challenge is to deal with this troublesome situation
in a manner that promises, over a period of time, to restore a solid base for sustained growth
and stability... Above all, the new measures should make abundantly clear our unwillingness to
finance a continuing inflationary process. (Volcker, 1979b, pp. 1-2, 4)
Before the National Press Club early in 1980, he underlined these monetary sources of sustained inflation.
Our policy, taken in a longer perspective, rests on a simple premise—one documented by centuries of experience—that the inflationary process is ultimately related to excessive growth in
money and credit. I do not mean to suggest that the relationship is so close, or that economic
reality is so simple, that we can simply set a monetary dial and relax...But, with all the complications, I do believe that moderate, non-inflationary growth in money and credit, sustained
over a period of time, is an absolute prerequisite for dealing with the inflation that has ravaged
the dollar, undermined our economic performance and prospects, and disturbed our society
itself. (Volcker, 1980a, pp. 3-4)
Chairman Volcker contended on January 15, 1980, that poor forecasts can undermine antiinflationary policy.
[I]t’s a dangerous game to change basic policies on the basis of short-term forecasts at any particular point in time. Forecasts of the short-run outlook are so often fallible that they’re almost
as apt to be wrong as right.
In the past, in shaping our nation’s policies, I think we’ve had an insidious tendency to anticipate the worst in terms of unemployment in particular; and we always anticipate the worst and
act on those anticipations over time. That’s a recipe for too much expansionary action and ultimately for inflation. Today our margins for error in that connection are less than they have ever
been and I think that we should not make that mistake again. (Volcker, 1980e, p. 42)
Then, before the Joint Economic Committee on February 1, he noted
the almost universal failure of forecasts made at this time last year, and throughout most of the
year, to predict accurately the continued expansion of economic activity in 1979. Despite the
shocks from very large oil price hikes, fuel shortages, and major strikes, as well as the imposition
of restraining macroeconomic policies, the economy proved to be remarkably resilient. Growth
in real economic activity did slow in 1979 from the unsustainable 5 percent rate posted in the
preceding year, but real GNP still advanced 1 percent over the four quarters of 1979; the muchheralded recession never appeared.
The 1979 experience underscores how limited our ability is to project future developments.
It reinforces the wisdom of holding firmly to monetary and other economic policies directed
510
November/December 2013
Federal Reserve Bank of St. Louis REVIEW
Centennial Issue
toward the evident continuing problems of the economy—of which inflation ranks first—rather
than reacting to possibly transitory and misleading movements in the latest statistics or relying
too heavily on uncertain economic and financial forecasts. In retrospect, recharting policy to
respond to tentative signs of a faltering economy last year would have proven extremely costly
to our anti-inflation effort. (Volcker, 1980b, p. 76)
In his first Humphrey-Hawkins testimony on February 19, 1980, Chairman Volcker amplified his critique of approaching monetary policy in such a way.
In the past, at critical junctures for economic stabilization policy, we have usually been more
preoccupied with the possibility of near-term weakness in economic activity or other objectives than with the implications of our actions for future inflation. To some degree, that has
been true even during the long period of expansion since 1975. As a consequence, fiscal and
monetary policies alike too often have been prematurely or excessively simulative or insufficiently restrictive. The result has been our now chronic inflationary problem, with a growing
conviction on the part of many that this process is likely to continue. Anticipations of higher
prices themselves help speed the inflationary process...
The broad objective of policy must be to break that ominous pattern. That is why dealing
with inflation has properly been elevated to a position of high national priority. Success will
require that policy be consistently and persistently oriented to that end. Vacillation and procrastination, out of fears of recession or otherwise, would run grave risks. Amid the present
uncertainties, stimulative policies could well be misdirected in the short run. More importantly,
far from assuring more growth over time, by aggravating the inflationary process and psychology, they would threaten more instability and unemployment. (Volcker, 1980d, pp. 2-3)
The reception given to the new operating procedures at the February Humphrey-Hawkins
hearings by the House and Senate banking committees was generally, though not universally,
welcoming. The House Committee on Banking, Finance, and Urban Affairs was chaired by
Representative Henry Reuss, a Democrat from Wisconsin. Despite his support, the tone of the
other representatives was mixed. Even so, the congressional committee’s monetary-policy report,
published in April, approved of “a cautious moderation of monetary growth in 1980 and into
the future for some years to come.” The report called the new operating procedures “a change
we applaud” and even recommended contemporaneous reserve requirements! (U.S. House of
Representatives, 1980c, pp. 2-4). William Proxmire, a Democrat from Wisconsin, although an
independent maverick, was chairman of the Senate Committee on Banking, Housing, and Urban
Affairs. He approved of the “aggressive” policy under Chairman Volcker. He even noted “continuing doubts that the Federal Reserve will continue to pursue a tight monetary policy in a
Presidential election year.” The only other senator to address the issue, Jake Garn, a Utah
Republican, also took an anti-inflationary position (U.S. Senate, 1980, pp. 1-3).
On a more technical level, an official summary of the operational details of the new procedures, dated January 30, 1980, appeared as an appendix to both testimonies by Chairman Volcker,
on February 1 and February 19, as well as to another of his testimonies on February 4, 1980
(Volcker, 1980c). This document identified and described in detail eight separate steps constituting the procedures. It also discussed
how the linkage between reserves and money involved in the procedures is influenced by the
existing institutional framework and other factors...The exact relationship depends on the
behavior of other factors besides money that absorb or release reserves, and consideration
Federal Reserve Bank of St. Louis REVIEW
November/December 2013
511
Lindsey, Orphanides, Rasche
must also be given to timing problems in connection with lagged reserve accounting. (U.S.
House of Representatives, 1980a, p. 1)
This document was released only after the Committee discussed on January 8, 1980, whether
to continue with the new procedures. Chairman Volcker began the discussion; it cannot be said
that the Committee’s decision turned into a suspenseful cliffhanger:
Chairman Volcker...I just want to be explicit about whether we want to continue this general
type of procedure. Obviously, we’re on it and it has worked; on the surface, anyway, it has worked.
The results are more or less in line with what was intended. And I think it continues to have some
of the advantages that were foreseen originally. While we still worry about what the federal funds
rate is doing, when it doesn’t go according to our preconception, we at least avoid making a concrete decision...
{A}s a broad thrust, I think the question is whether or not to continue basically what we’ve
been doing.
Mr. Partee. Shifting back from a very successful experiment certainly would be hard to explain.
Chairman Volcker. There’s no question.
Mr. Morris. The reaction would be devastating.
Mr. Partee. It surely would.
Mr. Balles. Unthinkable. (FOMC, Transcript, 1/8-9/1980, pp. 13-14)
Despite the technical description, some confusion about the new procedures persisted.
Governor Wallich expressed the point a month after the description was first released as follows:
The new procedures of the Federal Reserve have given rise to some understandable misconceptions that suggest that the Federal Reserve has not been fully effective in making itself understood.
(Wallich, 1980, p. 9)
WHY?
Looked at from a deeper perspective than mere historical narrative, the question can be
asked as to the reasons for the FOMC’s adoption of the new operating procedures—that is, why?
Listed roughly in order of decreasing obviousness, the reasons are as follows:
1.
2.
3.
4.
5.
restoring more certain public confidence in the Federal Reserve
by allowing more certain restraint over long-term inflation,
by more clearly abandoning a policy strategy of “gradualism” and
by gaining more certain control over intermediate-term money growth,
by clearly switching from the federal funds rate on the money-demand side to nonborrowed reserves on the money-supply side as the short-run operating target,
6. thereby permitting the federal funds rate more certain short-run flexibility to attain the
needed level in terms both of monetary and inflationary developments,
7. thereby more clearly distancing the FOMC from the particular day-to-day level of the
federal funds rate and
8. thereby clearly moving away from a deliberative smooth adjustment of the funds rate
and
512
November/December 2013
Federal Reserve Bank of St. Louis REVIEW
Centennial Issue
9. thereby clearly avoiding any reliance on uncertain FOMC estimates of potential output
or the Non-Accelerating Inflation Rate of Unemployment (NAIRU) and
10. thereby clearly avoiding any reliance on uncertain FOMC forecasts of output, employment, and inflation and
11. thereby clearly assuming full central bank responsibility for the attainment of long-term
price stability, but also
12. thereby more clearly avoiding difficult questions of overt responsibility for intermediateterm real-side developments.
Point One
The historical narrative in the last section helped to demonstrate that the media commentary
and commodity market reaction to the revelation on September 18 of the Board’s four-to-three
discount-rate vote—without the disclosure of the FOMC’s tightening and the accompanying
three dissents for even tighter policy—worked together to pound a fatal stake into the credibility
of the FOMC as the country’s bulwark against inflation. Had the public and the markets received
the full picture, then the reaction would very likely have been more subdued. Restoring the public’s
trust in the System became a paramount end for any actions that the FOMC would contemplate.
Point Two
According to the narrative history in the previous section, by October 6, 1979, the FOMC
evidently had come to view rampant inflation and inflationary expectations as the nation’s most
serious problem. Judged by actual events, the time had come for dramatic action by the Federal
Reserve to counter the inflationary threat to the nation’s economy. This action would need to be
sustained long enough to reduce inflation substantially as well as strengthen public attitudes about
the central bank’s resolve to do so, because intense inflationary forces and unhinged inflationary
expectations were seen to be detrimental to real-side activity. In the strength of its view, upon
which it was willing to act decisively, the FOMC was far ahead of its time. Indeed, as the 1970s
began, quite the opposite opinion prevailed—to wit, that some inflation was needed to “grease
the wheels” of the market system. Only after the long economic expansions of the last seven
years of the 1980s and the last eight years of the 1990s did the damaging effects of inflation rates
and expected rates of inflation above low single digits on saving, investment, and productivity
become demonstrable.
Point Three
A strategy of “gradualism” had characterized the FOMC’s monetary policy during the 1970s,
but the inadequacy of such a strategy had become all too evident as 1979 progressed. By the time
of its 1979 Annual Report on August 3, the IMF put it this way:
In the Fund’s 1976 Annual Report, the importance of bringing down inflation and greatly
reducing inflationary expectations was stressed. A “gradual” approach was recommended—
but one that “would need to be adhered to firmly...”
Now, three years later, it is clear that the suggested strategy of policy has not led to satisfactory
results; for the industrial countries, average rates of inflation and unemployment have not been
Federal Reserve Bank of St. Louis REVIEW
November/December 2013
513
Lindsey, Orphanides, Rasche
reduced. The reasons for this unsatisfactory outturn are manifold and complex, but perhaps the
basic one has been the pursuit of policies that have failed to make a dent in inflationary expectations. It is evident that governments have felt severe economic and political constraints in
launching an effective anti-inflation program, since in the short run this would be bound to
have adverse employment effects whose timing and magnitude would depend primarily on the
ability to reduce inflationary expectations and hence would be difficult to predict. Also noteworthy is that economic forecasting and policymaking have been subject to a substantial degree
of error in the unaccustomed situation of “stagflation”—an error often compounded, however
understandably, by official optimism toward the future or misleading assessments of past
developments...
The upshot has been that “gradualism” as an approach to the reduction of inflation and inflationary expectations has been too “gradual”—in many countries, to the point of no reduction
at all. This seems clearly evident from the fact that the overall rate of monetary expansion in
the industrial countries has not come down, but has remained about 10 percent in every year
since 1975... (IMF, 1979, p. 7)
The historical narrative in the previous section suggests that on October 6, the FOMC acted
on the same perception. The Committee clearly had become frustrated with the upward march
of inflation despite its previous gradualist policy put in place to resist the trend.
Point Four
As will be discussed more fully below in Point Eleven, Federal Reserve officials had long
accorded a significant role in the inflation process to excessive monetary stimulus, along with
the important effects imparted by “exogenous factors” that also affected measured inflation. As
will be seen in that discussion, however, Chairman Burns had questioned the practical ability of
monetary policy to resist the various pressures acting against sufficient monetary restraint to
maintain price stability. In opposition to that view, the position of the monetarists had the intellectual attraction of purity—that, on a sustained basis, “inflation was always and everywhere a
monetary phenomenon.” This argument had a universal acidity that dissolved all other influences
on long-term inflation, except for money growth. And the appreciable rise of actual inflation in
association with often-above-target money growth brought ever-widening support for the
monetarist argument that the culprit was none other than the Federal Reserve itself. Accordingly,
it was ever-more generally perceived that controlling money growth was a prerequisite for controlling inflation.
That money growth had been excessively rapid entering the fall of 1979 could not really be
questioned. In the third quarter of the year, the levels of M1 and M2 were 1½ percentage points
below the upper bounds of their respective 3 to 6 percent and 5 to 8 percent ranges for the year
only because of their respective low –2.1 percent and 1.8 percent rates of change recorded in the
first quarter. With M1 and M2 growing at respective rates of 7.6 percent and 9.5 percent in the
second quarter and of 8.6 percent and 11.9 percent in the third quarter, the Axilrod-Sternlight
memorandum informed the FOMC that
rates of growth have been accelerating and have been above the longer-run ranges, well above
most recently...
For the monetary aggregates as a group to be within their ranges by the time the year is over,
a considerable slowing from their recent pace is required. (Axilrod and Sternlight, 1979, p. 2)
514
November/December 2013
Federal Reserve Bank of St. Louis REVIEW
Centennial Issue
Taking a longer perspective, the two upper panels of Figure 5 show that, over each of the
last four years of the decade of the 1970s, either M1 or M2 growth exceeded the upper bound of
its announced annual range.8 This experience, of course, had added empirical support for the
contention that a causal link connected money growth and inflation. A decade after the procedural change, Stephen Axilrod summarized the approach as follows:
The obvious problem—it was an easy period in that sense—was to control inflation. One way
to do it was to impose an M1 rule on yourself, pay little attention to GNP forecasts, and just let
the economy adjust...[The FOMC] used M1 successfully as that sort of bludgeon to receive a
rapid reduction in inflation... (Axilrod, 1990, pp. 578-79)
Monetarists buttressed their case by contending that monetary targeting on a consistent
basis over time—that is, without “base drift”—would take advantage of the longer-run predictability of the velocity of money. Karl Brunner had underscored concern about base drift
under the old operating procedures.
It [the Shadow Open Market Committee] also warned that the Federal Reserve’s internal procedures were ill suited to execute an effective monetary control. The traditional mode of implementing policy would remain, in the Shadow Committee’s view, an uncertain and unreliable
instrument for the purposes defined by House Concurrent Resolution 133. The Committee
emphasized, moreover, the potential drift built into monetary growth as a result of the peculiar
targeting techniques evolved by the Federal Reserve Authorities. (Brunner, 1977, p. 2)
Effective monetary control would ensure, monetarists said, that prices would stay stable on
average over time and therefore that inflation expectations at more distant horizons would be
anchored at a low level. They contended that several economic advantages would flow from
such a situation. They also argued that high and volatile inflation and inflation expectations
made reliance on an interest rate as the main operating target for monetary policy even more
problematic than it already was otherwise. After all, the significance for spending of a particular
nominal interest rate was degraded as uncertainty rose about the true level of the real interest
rate and as speculative investment gained in importance.
Point Five
A separate argument of monetarism was about how to control money growth, asserting that
the monetary base or total reserves should be used as the operating target.9 The Shadow Open
Market Committee (SOMC) expressed the point this way in early February 1980:
The SOMC favors an immediate return to the 6% growth rate for base money that was achieved
in the first and second quarters of 1978. A 6% average rate of growth of the base in each quarter
of 1980 will continue the policy we advocated at our September 1979 meeting. (SOMC, 1980,
pp. 6-7)
This monetarist argument was rejected by FOMC staff, which drew on a different strand of
the literature to recommend nonborrowed reserves as the primary alternative operating target
to the federal funds rate. But this strand of the literature did not contend that as a technical matter
nonborrowed reserves were superior to the federal funds rate in an empirical horse race in which
each approach was used optimally in setting an operating target based on the expected outcome
Federal Reserve Bank of St. Louis REVIEW
November/December 2013
515
Lindsey, Orphanides, Rasche
Figure 5
SOURCE: Lindsey (1986, p. 177, Exhibit 5-1).
516
November/December 2013
Federal Reserve Bank of St. Louis REVIEW
Centennial Issue
for the money stock; rather, in such a case the two were virtually dead even in controlling money
(Sivesind and Hurley, 1980, pp. 199-203; Axilrod and Lindsey, 1981, pp. 246-52).
Instead, what tipped the scales in favor of nonborrowed reserves was the practical observation that a monetary authority deliberately setting the funds rate would be unlikely to select the
level that it expected to induce the targeted money stock because the implied volatility of the
funds rate would be more than the authority could stomach. Because of what Governor Wallich
called “inertia in the adjustment of the funds rate to needed levels under the old procedure,” a
nonborrowed reserves operating target was thought likely to work out better in practice in controlling money (Wallich, 1980, p. 5). Even if the authority chose an initial level that would not
give rise to the appropriate funds rate for the targeted money growth, further automatic movement of the funds rate within the control period but outside the authority’s discretion was believed
likely to deliver monetary growth closer to its target than in the case of a funds rate operating
target where the initial level was simply maintained. Over time, closer monetary management
would imply that inflation would be brought under more certain restraint as well.
Point Six
The Committee recognized that the switch to a reserves-based approach to monetary control would be more likely to allow the federal funds rate in the short run to move as necessary to
whatever level would prove consistent with more restrained money growth and lower inflation.
But given that the appropriate level, as well as the induced automatic movement, could not be
known in advance by the monetary authority, for the federal funds rate to have the scope to be
significantly more variable, the Committee would have to establish a substantially wider permissible band of funds rate movement. This band, which was published in the directive, is portrayed
in the lower panel of Figure 5 introduced in Point Four. On October 6, the Committee widened
this band from ½ percentage point to 4 percentage points. The small crosses in that panel, which
depict the average federal funds rate between FOMC meetings, also suggest that federal funds
in fact began trading over a much wider range.
Figure 6 offers an alternative perspective: A standard forward-looking Taylor rule has a tendency to predict a funds rate from early 1976 through mid-1979 that not only exhibits fairly
subdued movements but also comes reasonably close to the actual funds rate set by the FOMC.
(Figure 6, it should be noted, does not even employ the effects of a lagged funds rate to capture
the “interest rate smoothing” that the Committee unquestionably put in place along with its
reaction to forecasts of inflation and real economic activity over virtually all of the decade of the
1970s [Orphanides, 2002]). The figure’s Taylor rule uses Greenbook forecasts of inflation relative
to an assumed 2 percent target and of real GNP relative to the real-time estimates of potential output, as described in Orphanides (2003b). Other than its reliance on forecasts and data available
in real time to the FOMC for its policy deliberations, it follows Taylor’s (1993) classic parameterization, including the coefficients he originally suggested for the Committee’s responsiveness to
inflation and the output gap and his assumption of 2 percent for the equilibrium real funds rate.
Numerous studies over the past decade have suggested that adherence to such a policy rule should
represent rather good, if not optimal, monetary policy and should be expected to deliver reasonably good macroeconomic performance.10 By this rationale, and since the Committee’s actions
Federal Reserve Bank of St. Louis REVIEW
November/December 2013
517
Lindsey, Orphanides, Rasche
Figure 6
Forecast-Based Taylor Rule
Percent
20
Quarterly
October 1979
Federal Funds Rate
Taylor Rule
15
10
5
1976
1977
1978
1979
1980
1981
1982
up to the summer of 1979 line up well with the Taylor rule prescriptions, policy should have
been considered successful. However, it is precisely this reasoning that highlights the fragility of
supposedly efficient Taylor rule prescriptions. The strategy of exact adherence to this rule would
not have delivered much better outcomes than the policy in place before the reforms of October.
And adherence after October 1979 would have prevented the tightening necessary for controlling
inflation. Adoption of the new operating procedures shifted policy away from the pitfalls of the
unreliable guidance suggested by the Taylor rule.
Point Seven
Chairman Volcker explained in 1992 that he did not believe that he would have been able to
get the FOMC to accept overtly the increase in the funds rate that ultimately proved necessary
to rein in inflationary money growth.
[T]he general level of interest rates reached higher levels than I or any of my colleagues had really
anticipated. That, in a perverse way, was one benefit of the new technique; assuming that those
levels of interest were necessary to manage the money supply, I would not have had support for
deliberately raising short-term rates that much. (Volcker and Gyohten, 1992, p. 170)
Indeed, Chairman Volcker realized this potential difficulty with deliberate tightening in
real time. Greider wrote,
518
November/December 2013
Federal Reserve Bank of St. Louis REVIEW
Centennial Issue
Early in his tenure, Volcker had directed the senior staff to begin technical studies on changing
the Fed’s basic operating method, and after the embarrassment of the board’s 4-3 vote on
September 18, Volcker pushed the idea more aggressively. (Greider, 1987, p. 105)
Joseph B. Treaster put the point slightly differently in his book published in 2004.
In the middle of his second month as Fed Chairman, Volcker began developing a strategy for
implementing what would be the single most important decision of his career. His insight, triggered by the reaction to the close vote, was that as confident as he felt at the moment, there might
very well be a point, before inflation had been stopped, at which a majority at the Fed would say,
No more. “When you have to make an explicit decision about interest rates all the time,” Volcker
said years later, “people don’t like to do it. You’re always kind of playing catch-up. I wanted to
discipline ourselves.”
His solution, which now seems breathtakingly simple, was to take the cutting-edge decision
out of the hands of the members of the Fed—or at least make it seem that way... (Treaster, 2004,
pp. 147-48)
As Henry Wallich noted soon after the FOMC adopted the new procedures,
At the policy level, the reserve-based procedure has the advantage of minimizing the need for
Federal Reserve decisions concerning the funds rate. Interest rates become a byproduct, as it
were, of the money-supply process. (Wallich, 1980, p. 4)
William Greider quoted Governors Teeters, Rice, and Partee as to the desirability of automatic interest rate movements and their tendency to distance the outcome from the monetary
authority’s discretion.
“Under the new system,” Nancy Teeters observed, “we could say what we were doing was concentrating on the monetary aggregates. It was perfectly obvious to me that if you set the money
growth too low, that would send interest rates up. That was never in doubt. The problem with
targeting the Fed Funds rate is that you had to set it. This did let us step back a bit.”
Emmett Rice, who had joined the board four months earlier, had questioned interest-rate
targeting himself, convinced that it would make more sense to control reserves directly...“This
meant you were not directly responsible for what happened to interest rates. This was one of the
advantages. If interest rates had to go to 20 percent—and I have to say that nobody thought they
would go that high—then this would be the procedure doing it. I wouldn’t call it a cover, but I
don’t think anyone on the committee would have been willing to vote to push interest rates as
high as 20 percent. This was a way to achieve a result, a more effective way to get there.”
Chuck Partee, the other reluctant “dove,” was attracted to the operating shift by a different
argument. Partee was not a monetarist himself, but he thought that the monetarist approach
might overcome a flaw in the Fed’s institutional reflexes—sticking stubbornly with a strong position too long and causing more damage to the economy than it had intended...
“It may sound odd, but I would prefer the evenhanded approach of the monetarists. I became
very concerned about a mind-set that would lead us right in to a recession—get tight and stay
tight...I found myself far less hostile to the notion that we might have a fairer approach by targeting the money supply than I was to the idea that we should raise interest rates one time and
keep raising them. The problem is, there is also a hesitancy to reduce interest rates once they
have been raised. My concern grew out of my reflection on several earlier recessions, particularly
1974-1975. My concern was that we would be slow to respond to weakness and permit a substantial contraction in money and credit to occur. There would be a great chance of that, that
we might just get locked into a position of holding tight for a rather extended period.” (Greider,
1987, pp. 111-12)
Federal Reserve Bank of St. Louis REVIEW
November/December 2013
519
Lindsey, Orphanides, Rasche
Point Eight
Stephen Axilrod explained the import of the FOMC’s implicit decision to renounce interest
rate smoothing some 15 years after the new procedures were adopted.
[T]he Great Inflation [of the 1970s]...came about because of an interaction of a culture of
extreme policy caution and a number of unanticipated changes in the economic environment.
That is, in the culture of the time the policy instrument, say, the funds rate, was adjusted very
carefully—slowly and in small increments...In that context you can think about the policy of
1979-82 as an effort to break the culture of extreme policy caution. (Axilrod, 1996, p. 232-33)
Point Nine
After October 6, 1979, the FOMC set, and published in the policy record, short-run targets
for money growth over the three months ending in the last month of the current quarter, based
on the desired approach to the annual ranges that were announced in February and July in accord
with the Humphrey-Hawkins Act. With the nonborrowed reserves path derived from these targets, along with the Committee’s initial borrowing assumption, the evolution of the actual federal
funds rate between FOMC meetings would depend primarily on money-stock developments
relative to the targets over that period.
This process obviously has nothing to do with Committee estimates of the NAIRU or of the
associated estimates of potential output, nor does it have anything to do with gaps of unemployment or output from “full employment” levels. Actually, from a money-demand perspective,
outcomes for the growth of the money stock in the current quarter have more to do with the
growth of output ending in the current quarter than with an output gap (see, in particular,
Orphanides, 2003b, Section 2.5). As Orphanides has pointed out, misestimates of the NAIRU
and potential output and the associated misestimates of the unemployment and output gaps
were primary causes of the inflation of the 1970s (Orphanides, 2002, 2003a). Thus, it is understandable that the FOMC implicitly forswore gap analysis in the fall of 1979 (Orphanides, 2004;
Orphanides and Williams, 2004).
Figure 7 provides a graphical illustration of the gap analysis–based dilemma. As seen in the
middle panel, based on the available estimates of potential supply, actual output had fallen well
short of potential output and the gap was projected to deteriorate even before the fears of recession appeared on the horizon in 1979.11 This slack alone should have eventually led to a gradual
easing of inflationary pressures, which can be seen in the forecast of inflation in the top panel.
Throughout 1979, this reasoning suggested that holding back on tightening policy appeared to
provide a reasonable balance of the Committee’s objectives, affording gradual disinflation and
economic expansion. In retrospect, the 1979 estimates of potential proved overly optimistic,
explaining why the policy prescriptions from this gap-based analysis were overly expansionary.
But this was not recognized at the time. Continued adherence to gap-based analysis would have
prolonged the policy of inappropriate, even if inadvertent, monetary ease. The policy reform in
October short-circuited this process.
520
November/December 2013
Federal Reserve Bank of St. Louis REVIEW
Centennial Issue
Figure 7
Greenbook Monetary Policy Report Projections
Inflation (GNP Deflator Growth Over 4 Quarters)
Percent
12
11
January 31, 1979, Greenbook
July 3, 1979, Greenbook
10
9
8
7
6
5
1977
1978
1979
1980
1978
1979
1980
1978
1979
1980
GNP
Billions (1972 dollars)
1,550
1,500
January 31, 1979, Greenbook
July 3, 1979, Greenbook
Potential GNP
1,450
1,400
1,350
1,300
1977
Unemployment Rate
Percent
9.0
8.5
January 31, 1979, Greenbook
July 3, 1979, Greenbook
8.0
7.5
7.0
6.5
6.0
5.5
1977
NOTE: Vertical line segments indicate range of Board consensus projections as presented in the July 17, 1979, Monetary Policy Report.
Federal Reserve Bank of St. Louis REVIEW
November/December 2013
521
Lindsey, Orphanides, Rasche
Figure 8
Inflation Forecasts and Outcomes (Three-Quarter-Ahead Growth in GNP Deflator Over Four Quarters)
Percent
14
Quarterly
Greenbook Forecast
Actual
12
10
8
6
4
1972
1973
1974
1975
1976
1977
1978
1979
1980
1981
1982
Point Ten
The monetary policy process of short-run money targeting also is not explicitly dependent
on the longer-term economic forecasts of the Board members and Reserve Bank presidents.
Although their sense of the outlook implicitly could affect the Committee’s money targets, initial
borrowing assumption, and choice for the funds rate band, the influence of opinions about the
future of the economy over the actual course of the federal funds rate is clearly less direct than
with a federal funds operating target in which the Committee sets its operating objective based
in important part on its opinion of the outlook.
This much looser connection between the stance of policy and the uncertain economic
forecasts of FOMC members is, of course, consistent with Chairman Volcker’s denigration of
the accuracy of any economic forecasts that was cited above as well as Axilrod’s earlier observation that after the adoption of the new techniques the FOMC avoided basing policy on forecasts.
The new operating procedures, with their dependence on near-term outcomes for money, guaranteed that error-prone longer-term economic projections of both prices and real GNP would
not interfere with the coming battle against virulent and entrenched inflation.
The Board staff ’s economic projection in mid-1979 did not offer an accurate outlook for
real growth. Figure 7 confirms that, by July 1979, the Greenbook was predicting that a recession
had begun by the second quarter of 1979, as clearly shown by the forecasted decline in the level
of real GNP through the end of the year. (In retrospect, real GNP instead is known to have regis522
November/December 2013
Federal Reserve Bank of St. Louis REVIEW
Centennial Issue
tered positive growth in each quarter of that year.) The lower panel of Figure 7 displays the
associated staff prediction of a sharp rise in unemployment through the end of 1980. As a result
of the projections by the time of the July Greenbook, of steep increases in the output and employment gaps, along with moderating energy prices, average four-quarter deflator inflation was
foreseen to abate appreciably in 1980, after spiking through 1979.
The staff had established a history of excessive optimism in forecasting inflation in the 1970s.
Figure 8 demonstrates this record visually. It presents for the 1970s the successive underpredictions of the average four-quarter rate of inflation in the deflator in mid-quarter Greenbooks—
plotted in the quarter of that Greenbook’s publication—three quarters in advance of the last
predicted quarter, as in the Taylor rule noted in Point Six. The bias in the inflation forecasts, of
course, is closely related to the overly optimistic measures of potential supply discussed in Point
Nine. The inflation forecasts were systematically lower than they should have been simply because
of the persistent perceptions of economic slack that was not actually there. The evidence had
not yet been assembled showing that basing inflation forecasts on real-time estimates of the
output gap may be unreliable (Orphanides and van Norden, 2003).
Point Eleven
With its actions on October 6, the Committee fully assumed its unique responsibility for the
attainment of long-term price stability. To understand the nature of this change, it is necessary
to discuss the attitudes of previous FOMCs.
Under Chairman Burns, the common thread running through many communications on
monetary policy was that the Federal Reserve and other critical influences ultimately shared
responsibility for the too-rapid rise in prices. Excessive fiscal deficits were a commonly referenced
contributing source. The cost-push effect of union power through wage negotiations also was
regarded as playing an important role, as was corporate discretion over administered product
prices. After mid-decade, OPEC’s cartel-like pricing was thought to influence not just relative
prices but also overall trend inflation. By the 1970s, the economics profession had advanced
sufficiently that most FOMC members had accepted a vertical long-run Phillips curve in which
the equilibrium unemployment rate was independent of the inflation rate. Rather, despite rousing anti-inflationary speeches and testimony, the Federal Reserve had not really taken to heart
its own sole responsibility for the average rate of inflation over the long pull. It is the central
bank alone that has the duty of ensuring secular price stability, along with its other objective of
promoting maximum employment or, relatedly, sustainable economic growth, in the intermediate term. These objectives were enshrined in the Federal Reserve Act in 1977.
Although he never mentioned this 1977 statutory addition, former Chairman Burns presented the 1979 Per Jacobsson lecture in Belgrade on September 30, entitled “The Anguish of
Central Banking,” in which he delved more deeply into the dilemma of monetary policymaking—
attributing it to this fundamental factor:
the persistent inflationary bias that has emerged from the philosophic and political currents
that have been transforming economic life in the United States and elsewhere since the 1930s.
The essence of the unique inflation of our times and the reason central bankers have been inefFederal Reserve Bank of St. Louis REVIEW
November/December 2013
523
Lindsey, Orphanides, Rasche
fective in dealing with it can be understood only in terms of those currents of thought and the
political environment they have created...
Inflation came to be widely viewed as a temporary phenomenon—or provided it remained
mild, as an acceptable condition. “Maximum” or “full” employment, after all, had become
the nation’s economic major goal—not stability of the price level...Fear of immediate unemployment—rather than fear of current or eventual inflation—came to dominate economic
policymaking...
Viewed in the abstract, the Federal Reserve System had the power to abort the inflation at
its incipient stage fifteen years ago or at any later point, and it has the power to end it today. At
any time within that period, it could have restricted the money supply and created sufficient
strains in financial and industrial markets to terminate inflation with little delay. It did not do
so because the Federal Reserve was itself caught up in the philosophic and political currents
that were transforming American life and culture... (Burns, 1979, pp. 9, 13, 15)
Chairman Burns gave the following basic reason for why the role of the central bank in
fighting inflation in a democracy would be “subsidiary” and “very limited,” thus rendering it
able to cope “only marginally” with inflation, causing him to think that “we would look in vain
to technical reforms as a way of eliminating the inflationary bias of industrial countries” (Burns,
1979, pp. 21-22):
Every time the Government moved to enlarge the flow of benefits to the population at large, or
to this or that group, the assumption was implicit that monetary policy would somehow accommodate the action. A similar tacit assumption was embodied in every pricing or wage bargain
arranged by private parties or the Government. The fact that such actions could in combination
be wholly incompatible with moderate rates of monetary expansion was seldom considered by
those who initiated them, despite the frequent warnings by the Federal Reserve that new fires
of inflation were being ignited. If the Federal Reserve then sought to create a monetary environment that fell seriously short of accommodating the upward pressures on prices that were being
released or reinforced by governmental action, severe difficulties could be quickly produced in
the economy. Not only that, the Federal Reserve would be frustrating the will of Congress—a
Congress that was intent on providing additional services to the electorate and on assuring that
jobs and incomes were maintained, particularly in the short run.
Facing these political realities, the Federal Reserve was still willing to step hard on the monetary brake at times—as in 1966, 1969, and 1974—but its restrictive stance was not maintained
long enough to end inflation...As the Federal Reserve...kept testing and probing the limits of its
freedom to undernourish the inflation, it repeatedly evoked violent criticism from both the
Executive establishment and the Congress and therefore had to devote much of its energy to
warding off legislation that would destroy any hope of ending inflation. This testing process
necessarily involved political judgments, and the Federal Reserve may at times have overestimated the risks attaching to additional monetary restraint. (Burns, 1979, pp. 15-16)
In essence, Burns suggested that if a central bank had committed the expansionary errors
that generated inflation, as had happened in the late 1960s and 1970s in the United States, public
and political support appeared necessary to maintain the much tougher policies that might be
required to restore stability. Without such support, it could be questioned whether a central
bank had the mandate for such action. Nonetheless, Burns ended his lecture on an optimistic
note, observing that the political environment was indeed shifting in that direction.
When Chairman Volcker was appointed to the Board, public support of anti-inflationary
action had become quite high, and political sentiment appeared much more conducive than ever
524
November/December 2013
Federal Reserve Bank of St. Louis REVIEW
Centennial Issue
before to strong actions resisting inflation. By the late 1970s, public opinion polls consistently
identified inflation as a greater problem than unemployment. In any event, Chairman Volcker
said in an interview on PBS’s Commanding Heights (2000) that he had listened to and been much
affected by this lecture by Chairman Burns before he returned to Washington. He thought that
Chairman Burns was saying that as a practical matter the Federal Reserve was “rather impotent”
in fighting inflation. While that might have been the case earlier in the decade, Chairman Volcker
obviously disagreed that this assessment was still correct in 1979. In retrospect, he was right.
The FOMC at the end of the day proved able to live up to its obligation of being responsible for
establishing and maintaining stable prices over time.
Point Twelve
That a tightening of monetary policy could evoke “violent criticism” by “frustrating the will”
of a Congress intent on “assuring that jobs and incomes were maintained,” as Chairman Burns
contended, can be supported from the contemporaneous statements about the economic goals
of the elected officials themselves. For example, on October 19, 1979, the Senate majority leader,
Robert C. Byrd, Democrat from West Virginia, declared the following:
Attempting to control inflation or protect the dollar by throwing legions of people out of work
and shutting down shifts in our factories and mines is a hopeless policy. (Greider, 1987, p. 149)
As another example, Representative Henry S. Reuss, Democrat from Wisconsin, chairman
of the House Committee on Banking, Finance, and Urban Affairs, said this after the four-to-three
vote on the discount rate on September 18, 1979:
For the first time, Fed members are wondering out loud whether it really makes sense to throw
men and women out of work, and businesses into bankruptcy, in order to “rescue the dollar” by
chasing ever-rising European interest rates. (Berry, 1979, p. A1)
Although Representative Reuss was a general supporter of the new operating procedures, at
Chairman Volcker’s first Humphrey-Hawkins testimony on February 19, 1980, this is what he said:
Last year, following our first hearings, under the procedures established in Humphrey-Hawkins,
we issued a report on March 12, 1979, agreed to by all except one of our members.
The key recommendation of that report was “anti-inflationary policies must not cause a
recession.”
So far, the Federal Reserve’s policies have not caused a recession and for that, you deserve
our appreciation...
The Federal Reserve cannot cure inflation with monetary shock treatment and it shouldn’t
try. (U.S. House of Representatives, 1980b, pp. 1-2)
In 1982, with the economy having slid into a recession, both Republicans and Democrats
introduced legislation that would have required the Federal Reserve to keep real interest rates
within the range of historical experience, which could have potentially interfered with the conduct of monetary policy in a damaging manner.
In Point Three above, we saw that the IMF noted “that it is evident that governments have
felt severe economic and political constraints in launching an effective anti-inflation program,
since in the short run this would be bound to have severe employment effects.” Perhaps in part
Federal Reserve Bank of St. Louis REVIEW
November/December 2013
525
Lindsey, Orphanides, Rasche
to circumvent those political constraints, the FOMC members appreciated that the new procedures distanced them from the setting of the funds rate, as Point Seven demonstrated, and
Chairman Volcker’s answer to the question about real-side impacts in the press conference on
October 6, as quoted above, was sufficiently noncommittal that William Greider claimed that
“he evaded the point and concealed his real expectations” (Greider, 1987, p. 123).
But these inferences inevitably enter into the realm of speculation, because the motivation
of participants in the onrush of history is rarely specified at the time. Even so, it is difficult to
escape the conclusion that potential criticisms of FOMC policy by politicians, who in coming
years actually would show stirrings—by introducing legislation—of using their power to affect
the FOMC’s makeup or freedom of action, engendered in Committee members the desire to
obscure their responsibility for real-side developments.
“WHAT WE HAVE HERE IS A FAILURE TO COMMUNICATE!”—OR NOT!
Indisputably, market participants were somewhat confused, especially early on, by what the
new procedures were and what they portended for monetary aggregates and the money market,
let alone for longer-term interest rates, real magnitudes, and inflation. One diagnosis would be
to highlight a failure by the Federal Reserve to communicate the nature of its new policy approach
soon enough and with enough specificity to satisfy the public’s, and especially market participants’, pressing desire to know. In particular, between October 6, 1979, and February 1, 1980,
the FOMC did not release any detailed summary of its new technique. In consequence, at its
meeting on February 3-4, 1980,12 the SOMC held that
[t]he Federal Reserve should announce further details about its procedures to reduce the longrun trend of money growth and reestablish its credibility by actually achieving its announced
targets. This would be the most effective way to eliminate the entrenched belief that the rate of
inflation will continue to rise in the Eighties. (SOMC, 1980, p. 2)
Was one reason for this reticence that the FOMC was operating under a legacy of secrecy
inherited from the tenures of Chairmen Martin, Burns, and Miller? (See, Goodfriend, 1986.)
Could this tradition be used to explain, at least in part, why, for example, the Axilrod-Sternlight
memorandum was not released immediately? Immediate release of this memorandum shortly
after October 6 would have revealed, for all the world to see, a systematic, considered monetary
policy approach.
An alternative diagnosis would be that existing contingences, inevitable complexities, the
intended audience, and unavoidable uncertainties all posed severe challenges to clear communication, which could be surmounted only over time. As has already been seen in the historical
record, the FOMC actually had adopted the new operating procedures on a temporary, contingent
basis, awaiting evidence on just how effectively they would work given the uncertainties involved,
including those regarding money demand (FOMC Transcript, 10/6/1979, pp. 9-10, 15). However,
as Peter Sternlight learned, presumably to his chagrin, it is difficult to make the point initially
that new procedures have “experimental” elements without seeming to undercut the resolve
and understanding of the agency implementing them. As the rational expectations revolution
has emphasized, a “permanent” commitment has a much more powerful effect on expectations
526
November/December 2013
Federal Reserve Bank of St. Louis REVIEW
Centennial Issue
than a “temporary” one. To be sure, the FOMC did not stress publicly the contingent nature of
its adoption of the new operating technique. Still, the Committee did not discuss and reaffirm
its earlier tentative decision to adopt the new approach until it met on January 8, 1980. Only
afterward was Chairman Volcker ready to release publicly the “technical” description of the
new procedures, which he did on February 1, 1980.
In addition, the new procedures, without question, were complex. The Axilrod-Sternlight
memorandum, which describes the essence of the new procedure, was composed as a background
paper presenting a policy choice to the FOMC, for which their writing was well suited. It certainly
was not written with the simplicity and pedantry needed for public consumption. Financial
market participants are trained and paid primarily to buy low and sell high. Admittedly, they
have a longer attention span for digesting, and a greater capacity to grasp, Federal Reserve
analyses describing the intricacies of monetary policymaking than does the public at large. But
even with a hypothetical manual containing a perfect prediction and complete elucidation of
what the new procedures would be and how they would work, it is probable that market participants would have been able to assimilate the main features of those procedures only gradually
from practical experience.
Furthermore, certain features simply could not have been known by the Federal Reserve in
advance. Although the basic procedures had been considered before their approval on October
6, 1979, some elements could not have been settled except through the passage of time. Initially,
these inherently uncertain, and thus imperfectly describable, features included (i) how aggressive
the FOMC would be in setting and varying the monetary target paths, the initial borrowing
assumption, and the band for allowable funds trading; (ii) how extensive intermeeting policyrelated adjustments to the nonborrowed reserves target path would be; (iii) how extensive intermeeting technical “multiplier” adjustments to the nonborrowed reserves target path would be;
and (iv) how responsive the monetary aggregates, the real economy, and inflation would be to
these various ministrations.
FOMC communication, operating within this context, naturally had the obligation to strive
for maximum conciseness and clarity; but in judging the Federal Reserve’s success in public
communication in this case, especially late in 1979 and early in 1980, a historian must carefully
parse the words used by the principals. Take as an example the interview that appeared in the
WSJ on October 11, in which a contemporary reader may not consider the “Fed official” to be a
paragon of clear communication (see p. 206). But such a reading risks misinterpreting the meaning of the words used in what arguably was an informative description of a complex, responsive,
and discretionary monetary policy approach.
First, a “rule of thumb” was meant to convey something that the Federal Reserve certainly
was not going to propound: an oversimplified summary of a complex underlying system. Second,
at the time, the word “rule” by itself had a different meaning than it does today because John
Taylor’s famous usage, which has been adopted by the profession, has altered its definition among
economists to mean merely a “guideline” subject to judgmental overthrow. Then, the word “rule”
had been used influentially by Milton Friedman in the “rules versus discretion” debate to mean
a legislated requirement that would have to be followed strictly. Besides “nondiscretionary,” a
“rule”—also unlike today’s sense—was “nonresponsive” to current business cycle developments
Federal Reserve Bank of St. Louis REVIEW
November/December 2013
527
Lindsey, Orphanides, Rasche
as well, as in Friedman’s k-percent money growth rule or Allan Meltzer’s monetary base growth
rule. Only later did Allan Meltzer and Bennett McCallum introduce and advocate variable base
growth in a nondiscretionary rule, explicitly employing the concept of a “responsive, nondiscretionary rule” (Meltzer, 1987; McCallum, 1988). Third, the word “unpredictable” apparently did
not pass the Fed official’s lips; instead, it was the reporter’s word, although Chairman Volcker
did believe that some “uncertainty” about future monetary policy settings could be useful in curtailing “speculation” (Volcker and Gyohten, 1992, p. 170). Finally, today’s vantage point makes it
clear—although it may have been less clear in the interview—that the “Fed official” was saying,
not that a thought-out systematic structure of the new procedures did not “exist” (since it certainly did in the Axilrod-Sternlight memorandum), but rather that the Federal Reserve’s “future
behavior” hadn’t taken place and obviously couldn’t yet be pictured in detail. Only the passage
of time could clarify the emerging contours of the operational landscape.
WAS CHAIRMAN VOLCKER…
In attempting to draw lessons for the present day from the October 1979 policy reform, it
seems necessary to classify the essential characteristics that made Chairman Volcker’s FOMCs
successful at fighting inflation and setting the stage for Chairman Greenspan’s FOMCs to finish
the job. This section addresses the questions of whether Chairman Volcker was (i) a monetarist?
(ii) a nominal income targeter? (iii) a new, neo, or old-fashioned Keynesian? (iv) an inflation
targeter? or (v) a great communicator?
A Monetarist?
Chairman Volcker’s scientific views on the merits and demerits of the doctrine of monetarism arguably changed little during his years as president of the New York Federal Reserve
Bank and Chairman of the Board of Governors, judging by various FOMC transcripts, speeches,
and testimony. As already seen, he subscribed to the long-run connection between average
money growth and inflation, although some (but not all) nonmonetarist macroeconomists at
the time would have agreed with this secular linkage. He also expressed this point of view in
September 1976, when he presented an extended analysis of monetarism to an academic audience. He first characterized the school not only as having correctly insisted that money matters
but also as having
usefully emphasized the danger of confusion between nominal and real rates and the role of price
expectations. They have forcefully made the case for the view that in the long run velocity is not
related to the stock of money and that, in the same long run, an excess supply of money contributes not to real income or wealth but simply to inflation. (Volcker, 1976, p. 251-52.)
However, he then prophetically noted that
no one should be under the illusion that any tactical change will end controversy that, in the
last analysis, stems more from different judgments about relevant policy variables than about
operating techniques. (Volcker, 1976, p. 253)
528
November/December 2013
Federal Reserve Bank of St. Louis REVIEW
Centennial Issue
He outlined many of the disadvantages to money targeting that in the second half of 1982
would ring the death knell, though admittedly at first in a muted way, to monetary targeting at a
low growth rate:
[This points out] the simple fact that, whatever the stability in the relationship between money
and nominal income in the longer run, there is considerable instability in the relationship over
time horizons relevant to policymakers. Certainly the relationships between money, interest
rates, and nominal income have been unusual over the year or so since I rejoined the Federal
Reserve...I can only conclude that, in periods such as that we have just been through, we need
to be alert to possible shifts in the demand for money. (Volcker, 1976, p. 252)
He continued as follows:
[W]e must constantly balance the danger of underreacting to deviations of the aggregates from
target paths against the danger of overreacting...Clearly, there are risks in not responding to
bulges or shortfalls in the money supply relative to objectives...
But the danger of overreacting to deviations in the aggregates from targets is just as real...
Attempts to respond immediately to shifting reserve availability and allowing the money market
abruptly to tighten or ease could therefore easily result in whipsawing of the market...Since only
a relatively small fraction of the impact of a given move in reserve availability or money market
conditions is reflected in the behavior of the monetary aggregates in the short run, very large
movements in reserves and money market conditions might be needed to correct short-run
aberrations. Worse, the lagged effect of these moves might then have to be offset by even larger
movements in the opposite direction in the subsequent period—a process that could easily lead
to a serious disruption of the whole mechanism. (Volcker, 1976, p. 254)
He argued that if a central bank turns toward significant monetary restraint, it can induce
difficult reactions on the real side, with broader ramifications.
It is hardly a satisfactory answer to say that central banks in principle can always resist inflationary pressures by simply refusing to provide enough money to finance them. Set against
persistent expansionary pressures, aggressive wage demands, monopolistic or regulatory patterns that resist downward price adjustments, and other factors affecting cost levels, such an
approach would threaten chronic conflict with goals of growth and employment that must rank
among the most important national objectives. In a democracy, the risk would not be just to
the political life of a particular government, but to our way of government itself...
In this larger social and political setting, we should perhaps think of central banks themselves
as “endogenous” to the system. A theory of chronic inflation that points only to the money
supply is not going to prove adequate to understand—or deal with—inflation in today’s world.
The danger is that it may discourage the search for particular remedies for particular problems...
The monetarists, emphasizing old truths in modern clothing, have provided a large service
in redressing the balance. It is in pressing the point to an extreme that the danger lies—the
impression that only money matters and that a fixed rate of reserve expansion can answer most
of the complicated problems of economic policy. (Volcker, 1976, pp. 255-56)
As to the monetarist arguments on technical issues of operating procedures, he also articulated positions that foreshadowed the FOMC’s side in future debates and in the Staff Study in 1981.
While I do not pretend to econometric expertise, I do know that a massive amount of research
has been conducted in this area. The apparent result is that the relationship between money and
reserve aggregates, particularly in the short run, appears no more reliable than the relationship
between interest rates and money...
Federal Reserve Bank of St. Louis REVIEW
November/December 2013
529
Lindsey, Orphanides, Rasche
We have techniques to make the needed forecasts with both the interest rate and reserve
approaches. The trouble is that the forecast errors are large no matter what procedure is used,
particularly over periods of one to three months. Indeed, unimpressive as they are, I am told
some of the correlations observed in the historical data between reserve measures and monetary measures would prove to be spurious under a regime of rigid reserve targeting. (Volcker,
1976, pp. 253-54)
When the entire 13-paper Staff Study (BOG, 1981) was published, the Federal Reserve gave
the results a lot of play, ranging from an extended discussion in the February 1981 HumphreyHawkins report, to a press conference, to two conferences for economists (the conference for
academic economists was April 17, 1981, with lead-off statements from Karl Brunner and
Stephen Goldfeld, and the conference for market economists was April 21, 1981), to a Federal
Reserve Bulletin article by Stephen Axilrod (1981).
Monetarists did not believe that the FOMC had gone nearly far enough in the reforms of
October 1979 and seized on the Staff Study to reiterate their points. Milton Friedman critically
reviewed the experience (Friedman, 1982). Peter Sternlight and Stephen Axilrod vied in person
with Robert Rasche and Allan Meltzer in a heralded debate on April 30, 1981, at The Ohio State
University (Rasche et al., 1982). Even so, two of the Staff Study’s papers were published by Karl
Brunner, editor of the Journal of Monetary Economics.13 In addition, at a conference held at the
Federal Reserve Bank of St. Louis in October 1981, David E. Lindsey was asked to examine the
institutional changes needed to improve control of the money stock.14
Even during the period of monetary targeting, Chairman Volcker made his skeptical opinion of monetarism plain, first to Congress and then later to his FOMC colleagues.
Chairman Volcker...I would remind you that nothing that has happened—or that I’ve observed
recently—makes the money/GNP relationship any clearer or more stable than before. Having
gone through all these redefinition problems, one recognizes how arbitrary some of this is. It
depends on how you define [money]. (FOMC, Transcript, 1/8-9/1980, pp. 13-14)
Finally, the FOMC’s departure from low-growth monetary targeting after mid-1982, and
the subsequent downgrading of M1 itself as well as replacement of nonborrowed reserves with
borrowed reserves in the fall of that year, which are beyond the scope of this paper, suggest as
well that Paul A. Volcker did not qualify as a monetarist.
A Nominal Income Targeter?
Nominal income targeting was in the air in the late 1970s and early 1980s in the writings of
James Tobin, Bennett McCallum, Robert Gordon, and others. In a sense, money and nominal
income targeting could be viewed as closely related. Indeed, to emphasize this point, James Tobin
even referred to GNP targets as “velocity adjusted aggregates” (Tobin, 1985). Thus, the following
quotation from Chairman Volcker’s 1981 Humphrey-Hawkins testimony perhaps could be read
as the statement of a closet nominal-income targeter:
I would like to turn to the targets for 1981. Those targets were set with the intention of achieving further reduction in the growth of money and credit, returning such growth over time to
amounts consistent with the capacity of the economy to grow at stable prices. Against the background of the strong inflationary momentum in the economy, the targets are frankly designed
530
November/December 2013
Federal Reserve Bank of St. Louis REVIEW
Centennial Issue
to be restrictive. They do imply restraint on the potential growth of the nominal GNP. If inflation
continues unabated or rises, real activity is likely to be squeezed. As inflation begins noticeably
to abate, the stage will be set for stronger real growth. (Volcker, 1981, pp. 5-6)
However, this interpretation would be inaccurate. To be sure, monetary targeting would
constrain the growth of nominal GNP, which is what Chairman Volcker was pointing out. But
literal nominal GNP targeting would not have met with his approval, at least in the environment
facing the Committee in 1979, for two reasons at a minimum.
First, a more directly controllable intermediate target than GNP was necessary to restore
the public’s confidence in the Federal Reserve’s commitment to conquering inflation. While
policy could be adjusted to maintain M1 growth within an announced range over relatively short
periods, thus demonstrating that the Federal Reserve meant business, that could not be said of a
nominal GNP target. The lags in the transmission process were, as they remain, too long, uncertain, and variable for that purpose, and too many other factors outside a central bank’s control
influence nominal income over short intervals. Second, nominal income targeting would not
have represented as stark a break from the gradualist policies of the past as the Committee must
have felt was necessary. As described by Tobin, and in light of the policy lags involved, nominal
income targeting would require the central bank to continue to fine-tune the stance of policy on
the basis of predictions of the future, hardly a recipe for success given the profession’s sad forecasting record earlier in the 1970s. Stephen Axilrod later offered the following summary regarding the superiority of monetary targets:
A money supply guide has two virtues: the central bank can be held reasonably responsible and
accountable for its achievement, and it will serve as an anchor to the windward against erroneous
assessments of ongoing and predicted economic and price developments. (Axilrod, 1985, p. 600)
In 1979, Chairman Volcker himself clearly put predominant priority on conquering inflation. Nominal GNP targeting did not appear as certain a strategy for gaining the public’s confidence and for fairly promptly achieving that goal as monetary targeting did.
A New, Neo, or Old-Fashioned Keynesian?
A basic policy recommendation arising from the Keynesian framework, old, new, and neo-,
is that policy can be successful in stabilizing the economy by aiming to align aggregate demand
with the nation’s potential supply. In one sense, the theoretical argument behind this reasoning
is impeccable, under the assumption that the implied policy prescription can be applied in practice. But Volcker rejected the premise that policy should actively seek to close output or unemployment and related gaps, judging that the informational requirements of such calculations
were simply untenable.
The original Taylor rule, which used outcomes for the estimated output gap, that is, actual
output less potential output, provides a useful illustration of the gap-closing Keynesian perspective. But unlike this Taylor rule, the reaction function consistent with targeting money growth
instead, from a money-demand perspective, would use outcomes for estimated output growth.
That is, whereas the Taylor rule stresses the role of the output gap for setting policy, a reaction
function for controlling money growth would instead stress the growth rate of output relative to
Federal Reserve Bank of St. Louis REVIEW
November/December 2013
531
Lindsey, Orphanides, Rasche
that of potential—that is, the change in the output gap. And indeed, estimated policy reaction
functions suggest that, while Federal Reserve policy appeared to respond to such gaps quite
strongly before Volcker became Chairman, this was no longer the case afterward (Orphanides,
2003b, 2004).
Because he had little tolerance for gap analysis, it is clear that he should not be placed in any
of these camps. It is less certain that these camps were any more tolerant of inflation than he
was, but he obviously had a very low tolerance for inflation.
An Inflation Targeter?
Does that mean that he anticipated today’s advocates of inflation targeting, such as
Governor Ben Bernanke, Thomas Laubach, Rick Mishkin, Adam Posen, and the current IMF
or the central bank practitioners in New Zealand, Australia, Canada, England, Sweden, Korea,
Poland, and South Africa?15 Not really, to the extent that they attempt to heighten central bank
transparency through an announced, explicit numerical target or range for the inflation rate.
Instead, in a speech before an audience of academics in 1983—jocularly called “Can We Survive
Prosperity?”16—Chairman Volcker proposed a qualitative definition of price stability.
A workable definition of reasonable “price stability” would seem to me to be a situation in which
expectations of generally rising (or falling) prices over a considerable period are not a pervasive
influence on economic and financial behavior. Stated more positively, “stability” would imply
that decision-making should be able to proceed on the basis that “real” and “nominal” values
are substantially the same over the planning horizon—and that planning horizons should be
suitably long. (Volcker, 1983, p. 5)
His disdain for forecasts as a policymaking tool also would have turned him against some
recent practices for attempting to attain an inflation target. All things considered, he certainly
didn’t sound like a prototypical inflation targeter.
A Great Communicator?
In his days as president of the New York Federal Reserve Bank, he referenced approvingly
the degree of openness in the policy record:
I might note in passing that the amount of information provided in these records probably sets
a standard among the major central banks in the world, and represents a degree of openness
entirely unknown to a central banker of an earlier generation. (Volcker, 1976, p. 253)
Chairman Volcker advanced the case for effective communication early in his tenure at the
Board, as well as the advantages of monetary targeting in this regard.
All of this puts a special burden on those of us developing and implementing policy to “get it
right,” to communicate our purposes and intentions effectively, and to persevere with needed
policies.
In that context, I am satisfied that the greater emphasis we have placed on monetary targeting in recent years, supplemented by the change in operating techniques, has assisted both in
communicating what we are about and achieving the internal discipline necessary to act in a
timely way. (Volcker, 1980f, p. 6)
532
November/December 2013
Federal Reserve Bank of St. Louis REVIEW
Centennial Issue
For the not-quite-three years of serious (if not always effective) short-term monetary targeting, FOMC communication indisputably was more transparent than in the surrounding years,
when the FOMC did not intend for its communication to be very open—and succeeded admirably
in realizing its intention. Despite the transparency under monetary targeting, the Committee
was accused of adopting the new operating procedures only as a smokescreen to obscure its
intention to markedly increase short-term interest rates. We have found no evidence to substantiate this claim and therefore consider it invalid. Instead, what does make for a fascinating debate,
as there are two legitimate sides, is whether the Committee’s communication during the period
of monetary targeting moved toward openness as completely as it should have. In what follows,
we try in a single discussion to give the flavor of each side of the debate.
The fanfare surrounding the announcement of the new procedures, the testimonies of
Chairman Volcker and other Board members, the speeches by Board members and Reserve
Bank presidents, the Humphrey-Hawkins reports, the official staff studies, the Bulletin article,
and the unofficial staff papers must have served a communications end. The general principles
underlying the new approach were well explained, and the FOMC, if only by dint of repetition,
must have gotten these messages across over time, at least to some extent.
To be sure, the Committee convinced most observers that it meant business in large measure
only by successfully reducing actual inflation as time went on. Survey responses regarding inflationary expectations and long-term interest rates did not respond immediately to the Federal
Reserve’s new operating procedures and associated stirring words; instead, it took some years,
along with the reduction in actual inflation, for them to come down on a sustained basis. Market
participants understandably would have been somewhat skeptical initially that real reforms
would continue when the going got rough, so they needed to see the lower inflation results before
they would fully believe that a “regime change” had occurred. Whether publicly quantifying its
inflation goal would have allowed the FOMC to shorten this period of adjustment can be debated.
In any event, observers on the outside from the beginning could see the new operating procedures
working themselves out in money markets as advertised in those Federal Reserve descriptions.
While the Federal Reserve did not publish its short-run target paths for M1 and reserves, let
alone the Federal Reserve’s daily balance sheet or the reserve factor forecasts made by staff at
the Trading Desk and the Board, most people on the outside did not care to know about the
detailed plumbing of the new monetary control procedures.17 Instead, they just wanted to be
sure that those on the inside were in fact minding the store and would “get it right,” in Chairman
Volcker’s phrase.
The communications problems that did emerge concerned the public’s basic understanding
of exactly what constituted “getting it right,” because effective monetary targeting proved to be
no easy matter. Although beyond the scope of this paper, the increasing challenges of monetary
targeting and the eventual departure from it via a nonborrowed reserves-based operating procedure, whatever the departure’s merits or demerits, in Chairman Volcker’s mind clearly could
not be discussed openly—despite its only temporary adoption in the first place—perhaps partly
in light of the favorable public comments the FOMC had made about the approach.
This brings us to the basic question of whether Chairman Volcker could be classified as a
great, or even mediocre, communicator? One aspect of this question in turn can be decomposed
Federal Reserve Bank of St. Louis REVIEW
November/December 2013
533
Lindsey, Orphanides, Rasche
thusly: Was communication about the future stance of policy transparent, and why or why not?
Was communication about the present stance of policy transparent, and why or why not?
The first component question is the easier to answer. As a simple matter of pure logic, knowing and revealing publicly anything about the future stance of policy requires knowledge not
only about the FOMC’s ultimate objectives and future reaction function but also about the outlook for economic activity and inflation. As the historical narrative repeatedly demonstrated,
Chairman Volcker was not just skeptical about but almost dismissive of economists’ attempts to
forecast the future. Indeed, he expressed the view that basing policy on such efforts had proven
to be a counterproductive strategy in the 1970s. Given that attitude, he certainly would not have
wanted the central bank to suffer the indignity of having its public statements about its own
future policy stance, which necessarily would have had to rest on those same error-prone forecasts, frequently proven wrong by the march of events. This was obviously the case during the
episode of monetary targeting. Even after the fall of 1982, when the Committee was instructing
the Desk to pursue a borrowing operating target, the FOMC did not try to hint at what the future
level of borrowing might be.
The answer to the second component question, about publicly describing the current policy
stance, is much more difficult to prove—though not to provide—because it is necessarily more
speculative. People tend not to express “politically incorrect” sentiments—to use the term former Governor Laurence Meyer has recently employed in a different macroeconomic context—
on the record for historians later to uncover (Meyer, 2004, pp. 75-76). Thus, much of what follows
cannot be conclusively demonstrated, but is based on the “atmospherics” around the Board in
the 1980s (David Lindsey’s recollection). A major role was played by political threats to FOMC
independence, which also is largely beyond the scope of this paper, as is politicians’ switch to
deploying an altogether different strategy in the first half of the 1990s, which involved certain
issues of transparency, and naturally induced an alternative defensive posture by the Federal
Reserve. The post-1982 threats to Federal Reserve independence came from members of both
parties in the Congress and fed back on the lack of transparency of the Federal Reserve under
Chairman Volcker. Particularly in the post-monetary-targeting portion of his tenure as Board
Chairman, the FOMC was guarded in its communicative detail. Indeed, the FOMC of this period
revealed its propensity for “constructive ambiguity,” a term that always could be used in polite
company. A less-inhibited modern observer instead might call the Committee “opaque” or, even
worse, “non-transparent.”
Actually, what is not so transparent to the modern observer was precisely the Committee’s
defensive motivation at the time. An important concern was to avoid criticism, which could
well have resulted in political pressure, which in turn could well have adversely affected the
conduct of monetary policy. It is worth remembering that congressional criticism of what would
now be termed sound, anti-inflationary monetary policy was not uncommon at the time. Sharp
criticism of interest rate hikes by politicians, who ultimately might be successful in passing legislation altering the Federal Reserve’s makeup or limiting its maneuvering room, would only render an already difficult decision to tighten even more difficult.
Without transparency, a decision that likely or certainly would have raised the funds rate,
but not the discount rate, would not have been known even to the market cognoscenti any earlier
534
November/December 2013
Federal Reserve Bank of St. Louis REVIEW
Centennial Issue
than the next day through the signals imparted by the operations of the Trading Desk. And the
action might or might not have been covered in financial news stories on the business pages of
the newspapers, but not before the day after that. By then the news would have been sufficiently
outdated that few politicians would have bothered to comment in real time.
By contrast, with the transparency of, for example, an immediate announcement of a change
in the stance of policy, reports by the media would have been immediate. Commentators, including politicians, would have given their reactions on camera the same afternoon. The story would
have been covered in the television news programs that evening and then would have appeared
on the front pages of the major newspapers the next day. In other words, transparency would
have transformed the action from a little-noticed technical adjustment in the obscure market for
bank reserves into a big deal. In the resulting goldfish bowl, tightening would have been harder
to decide to do—yielding worse monetary policy and hence inferior national economic results.
In light of these considerations, Volcker’s advice to a “new central banker,” as recounted by
Mervyn King, is entirely understandable:
When I joined the Bank of England in 1991, I was fortunate enough to be invited to dine with a
group that included Paul Volcker. At the end of the evening I asked Paul if he had a word of
advice for a new central banker. He replied—in one word—“mystique.” That single word encapsulated much of the tradition and wisdom of central banking at that time. (King, 2000)
This advice is, of course, not that of a great communicator.
Summary
The fundamentally negative answers to the last several questions imply that Chairman
Volcker cannot readily be pigeonholed. To be sure, he unswervingly held to the end of vanquishing inflation. However, he was pragmatic in his choice of means. Paul A. Volcker, whose FOMCs
went much of the way to conquering inflation, was a true original.
CONCLUSIONS
Inflation was well entrenched in the United States by the time President Carter appointed
Paul Volcker Chairman of the Federal Reserve in 1979. For more than a decade, the Federal
Reserve had attempted to cure the problem with a seemingly appropriate gradualist approach.
By nudging short-term interest rates in small steps, monetary policy could be sufficiently expansionary to support reasonably high employment and growth, thereby avoiding recession, while
at the same time restrictive enough to maintain some slack in aggregate demand, thereby making
progress on inflation. In theory, by focusing on short-run demand management, both economic
stability and gradual progress on inflation could be attained. Instead, this approach delivered
instability and an ever-worsening inflationary psychology.
In 1978, Paul Volcker had already recognized that an approach placing greater emphasis on
controlling inflation, instead of the strategy in place, would be more fruitful.
Wider recognition of the limits on the ability of demand management to keep the economy at a
steady full employment path, especially when expectations are hypersensitive to the threat of
Federal Reserve Bank of St. Louis REVIEW
November/December 2013
535
Lindsey, Orphanides, Rasche
more inflation, provides a more realistic point for policy formulation. So do the increasing, and
in my mind well-justified, concerns with the problem of inflation by the national administration
and by the citizenry. (Volcker, 1978, pp. 61-62)
Throughout the first half of 1979, Volcker was part of a vocal minority on the FOMC noting
that the inflationary situation was approaching crisis proportions. But agonizing fears of recession kept the majority in Chairman Miller’s FOMC from tightening policy to the extent necessary to contain inflation. President Carter’s nomination of Paul Volcker to be Chairman of the
Federal Reserve in late July started to shift this balance. But by late September 1979, the FOMC
came to face the underlying crisis that Paul Volcker had worried aloud about since the first FOMC
meeting of the year: mounting inflationary momentum and accompanying heightened inflation
expectations. In addition, a policy crisis had recently emerged as well, whose proximate trigger
was the reaction in the media and commodity markets to the four-to-three split of the Board of
Governors in its discount rate vote on September 18. Prior to that vote but after his nomination
as Chairman on July 25, Volcker had been portrayed in the media as an invincible general leading the war against inflation. By contrast, in its reporting on the discount-rate vote, the media
pictured Volcker as a general whose troops, if not deserting, were in major retreat. Jumps in
commodity prices also revealed that the FOMC had lost credibility regarding its commitment
to an anti-inflationary policy.
A “strategic plan” was required that would restore the public’s faith in the FOMC and contain “inflationary psychology.” It had become clear to the FOMC that the “plan” had to be made
public, break dramatically with established practice, allow for the possibility of substantial
increases in short-term interest rates, yet be politically acceptable, and convince financial market
participants and people more generally that it would succeed. The new operating procedures,
focusing on using nonborrowed reserves to keep monetary growth within the announced ranges
for the year, satisfied these conditions. The available record does not suggest that the FOMC was
converted to monetarist ideology. The “monetarist experiment” of October 1979 was not really
monetarist! Rather, the new techniques were conditionally adopted for pragmatic reasons—
there was a good chance that they would succeed in restoring stability. In essence, the Committee
accepted that, under the prevailing circumstances, controlling monetary growth presented a
robust approach to taming inflation. The “plan,” while undoubtedly not perfect, turned out to
be pretty good. It accomplished its major objectives of reversing rising inflationary expectations
and taking the crucial initial steps in a two-decade-long journey back to price stability. And,
perhaps as important, it instilled a focus on controlling inflation and inflationary expectations
as an enduring aspect of Federal Reserve monetary strategy. ■
536
November/December 2013
Federal Reserve Bank of St. Louis REVIEW
Centennial Issue
NOTES
1
Volcker (1978, p. 61).
2
For a description of the operating procedures prior to the reforms, see Wallich and Keir (1979). See Axilrod (1981) and
Lindsey (1986) for descriptions of the new operating procedures.
3
Governor Partee served on the senior staff of the Board of Governors for many years before his appointment to the
Board, which began January 5, 1976. The terms of members of the Board expire on January 31 of even-numbered
years.
4
See Kichline (1979a,b,c).
5
Light editing that actually appears in the official transcripts is shown here with brackets, [ ]. Further editing we have
done for this paper is shown with braces, { }.
6
In addition to Chairman Volcker, the three previous Federal Reserve Chairmen were at the Belgrade meeting.
Chairman Miller was attending as Treasury secretary. And Chairman Martin was to introduce Chairman Burns, who
was giving the Per Jacobsson lecture that year. Burns took the occasion to deliver his remarkable “The Anguish of
Central Banking,” which we return to later on.
7
While he expressed some doubt as to whether the Federal Reserve would follow through with the program,
Greenspan was certainly supportive. Indeed, in congressional testimony on November 5, 1979, he strongly defended
the Federal Reserve: “I thus conclude that for the United States there is little leeway for policy maneuvering in the
monetary area and that the focus, as it should have been all along, must be on defusing underlying inflationary pressures...1980 is likely to be a recession year and high interest rates are unquestionably going to exaggerate and prolong any recession. It would be a mistake, however, to attribute the interest rate increases to the Federal Reserve. Its
options are limited. The problems reflect earlier inflationary policies. Unless and until we can reverse them, a restoration of balance in our economy will remain illusive” (U.S. Congress Joint Economic Committee, 1980, pp. 7-8).
8
This figure is reproduced from Lindsey (1986, p. 177, Exhibit 5-1).
9
See, for example, Johannes and Rasche (1979, 1980, 1981). Table 1 in the 1981 paper translates the “New Federal
Reserve Technical Procedures for Controlling Money” into the money multiplier framework used by monetarists.
10 See, for example, the studies in Taylor (1999).
11 Potential output is from the Council of Economic Advisers (1979, p. 75). This estimate, which was prepared in
February 1979, was also employed by the Federal Reserve Board staff as its estimate throughout 1979.
12 The SOMC meeting was on Sunday, February 3, 1980, so the members of the committee were not aware of the
attachment to Volcker’s February 1 Joint Economic Committee testimony.
13 Tinsley, von zur Muehlen, and Fries (1982); Lindsey et al. (1984).
14 See Lindsey (1983).
15 See Bernanke et al. (1999).
16 Early in the preparation process for this speech, he even more jocularly suggested the following title: “What Economists
Don’t Know—That Can Hurt You!” (David Lindsey’s recollection.)
17 At the January 1980 FOMC meeting, President Roos asked about heightening market knowledge and “dynamism” by
releasing the reserve paths publicly. Peter Sternlight replied that intermeeting adjustments to those paths would
only sow confusion if the quantitative process were carried out in public. He said, though, that more explanation of
the “general methodology” would be warranted (FOMC, Transcript, 1/8-9/1980, pp. 9-10).
REFERENCES
ABC News’ Issues and Answers. Transcript. October 29, 1979.
Allen, John H. “Bond Prices Score Strong Gains.” New York Times, September 20, 1979, p. D9.
Axilrod, Stephen H. “New Monetary Control Procedure: Findings and Evaluation from a Federal Reserve Study.” Federal
Reserve Bulletin, April 1981.
Federal Reserve Bank of St. Louis REVIEW
November/December 2013
537
Lindsey, Orphanides, Rasche
Axilrod, Stephen H. “Consequences and Criticisms of Monetary Targeting: Comment.” Journal of Money, Credit, and
Banking, November 1985, 17(4, Part 2), p. 60.
Axilrod, Stephen H. “Comment” in Financial Sectors in Open Economies: Empirical Analysis and Policy Issues. Washington,
DC: Board of Governors of the Federal Reserve System, 1990.
Axilrod, Stephen H. “General Discussion” presented at the symposium Achieving Price Stability, sponsored by the
Federal Reserve Bank of Kansas City, 1996.
Axilrod, Stephen H. and Lindsey, David E. “Federal Reserve System Implementation of Monetary Policy: Analytical
Foundations of the New Approach.” American Economic Review, Papers and Proceedings, May 1981, pp. 246-52;
presented at the American Economic Association Meeting, Denver, CO, September 6, 1980.
Axilrod, Stephen H. and Sternlight, Peter. “Proposal for Reserve Aggregates as Guide to Open Market Operations,”
October 4, 1979, Memorandum to the Federal Open Market Committee, in Federal Open Market Committee,
Transcript, Conference Call. Washington, DC: Board of Governors of the Federal Reserve System, October 5, 1979.
Bennett, Robert A. “Reserve Board, by 4-3, Raises Rate on Loans to Banks to Record 11%.” New York Times, September
19, 1979, p. A1.
Bernanke, Ben S.; Laubach, Thomas; Mishkin, Frederic S. and Posen, Adam S. Inflation Targeting: Lessons from the
International Experience. Princeton, NJ: Princeton University Press, 1999.
Berry, John. “Fed Lifts Discount Rate to Peak 11% on Close Vote.” Washington Post, September 19, 1979, p. A1.
Board of Governors of the Federal Reserve System. Minutes. Washington, DC: various dates.
Board of Governors of the Federal Reserve System. 66th Annual Report of the Board of Governors, 1979. Washington,
DC: 1979a.
Board of Governors of the Federal Reserve System. Greenbook for the February 6, 1979, meeting. Washington, DC:
January 31, 1979b.
Board of Governors of the Federal Reserve System. Bluebook. Washington, DC: February 2, 1979c.
Board of Governors of the Federal Reserve System. Press Release. Washington, DC: October 6, 1979d.
Board of Governors of the Federal Reserve System. Transcript of Press Conference. Washington, DC: October 6, 1979e.
Board of Governors of the Federal Reserve System. New Monetary Control Procedures. Volumes I and II, Federal Reserve
Staff Study. Washington, DC: February 1981.
Brunner, Karl. “The Dilemma of Inflationary Policies.” Position paper prepared for the 9th meeting of the Shadow Open
Market Committee, September 19, 1977.
Burns, Arthur F. “The Anguish of Central Banking.” Per Jacobsson Lecture, Belgrade, Yugoslavia, September 30, 1979.
Carter, Jimmy. White House Statement, October 6, 1979, in Public Papers of the Presidents of the United States: Jimmy
Carter, 1979. Book II. Washington, DC: Government Printing Office, 1980.
Commanding Heights. PBS Interview with Paul Volcker, Transcript, September 26, 2000,
http://www.pbs.org/wgbh/commandingheights/shared/minitextlo/int_paulvolcker.html.
Council of Economic Advisers. 1979 Economic Report of the President. Washington, DC, 1979.
Clark, Lindley H. Jr. “The Monetarists Grow Wary.” Wall Street Journal, October 12, 1979, p. 22.
Conderacci, Greg. “Fed Warns That Unpredictable Posture Will Continue as Part of Its Policy Switch.” Wall Street Journal,
October 11, 1979, p. 3.
Cowan, Edward. “High-Interest Foes Fear Deeper Slump.” New York Times, September 20, 1979, p. 1.
Federal Open Market Committee. Transcripts. Washington, DC: Board of Governors of the Federal Reserve System:
various dates.
Federal Open Market Committee. Briefing. Washington, DC: Board of Governors of the Federal Reserve System: May 22,
1979a.
538
November/December 2013
Federal Reserve Bank of St. Louis REVIEW
Centennial Issue
Federal Open Market Committee. “Report of Open Market Operations.” FOMC Meeting. Washington, DC: Board of
Governors of the Federal Reserve System: August 14, 1979b.
Friedman, Milton. “Monetary Policy: Theory and Practice.” Lecture delivered July 5, 1981; Journal of Money, Credit, and
Banking, February 1982, 14(1), pp. 95-118.
Garino, David P. “St. Louis Fed Is Jubilant Over New Stress on the Money Supply in Monetary Policy.” Wall Street Journal,
October 9, 1979, p. 6.
Goodfriend, Marvin. “Monetary Mystique: Secrecy and Central Banking.” Journal of Monetary Economics, January 1986,
17(1), pp. 63-92.
Greider, William. Secrets of the Temple: How the Federal Reserve Runs the Country. New York: Simon & Schuster, 1987.
Herman, Tom. “Bankers Foresee Problems in Executing And Enforcing Fed Anti-Inflation Plan.” Wall Street Journal,
October 11, 1979, p. 6.
International Monetary Fund. Developments in the World Economy: Annual Report. Washington, DC: August 3, 1979.
Johannes, J.M. and Rasche, Robert H. “Predicting the Money Multiplier.” Journal of Monetary Economics, July 1979, 5,
pp. 301-25.
Johannes, J.M. and Rasche, Robert H. “Monetary Control: The Implementation Experience, Retrospective and
Prospective,” in Karl Brunner, ed., A Symposium on the Federal Reserve and Its Public Accountability. Rochester, NY:
Center for Research on Government Policy and Business, Graduate School of Management, University of Rochester,
1980, pp. 49-87.
Johannes, J.M. and Rasche, Robert H. “Can the Reserves Approach to Monetary Control Really Work?” Journal of
Money, Credit, and Banking, August 1981, 13, pp. 298-313.
Kichline, James L. FOMC Briefings. Washington, DC: Board of Governors of the Federal Reserve System: March 20,
1979a; April 17, 1979b; May 22, 1979c.
King, Mervyn. Address to the joint luncheon of the American Economic Association and the American Finance
Association, Boston, MA, January 7, 2000.
Lindsey, David E. “Nonborrowed Reserve Targeting and Monetary Control,” in Laurence H. Meyer, ed., Improving Money
Stock Control. Boston: Kluwer-Nijhoff Publishing, 1983; Presented at the conference Improving Money Stock Control:
Problems, Solutions, and Consequences, co-sponsored by the Federal Reserve Bank of St. Louis and the Center for
the Study of American Business, Washington University, St. Louis, MO, October 30, 1981.
Lindsey, David E. “The Monetary Regime of the Federal Reserve System,” in Colin D. Campbell and William R. Dougan,
eds., Alternative Monetary Regimes. Baltimore: The Johns Hopkins University Press, 1986.
Lindsey, David E.; Farr, Helen T.; Gillum, Gary P.; Kopecky, Kenneth J. and Porter, Richard D. “Short-Run Monetary
Control: Evidence under a Non-Borrowed Reserve Operating Procedure.” Journal of Monetary Economics, January
1984, 13(1), pp. 87-111.
MacNeil-Lehrer News Hour. Transcript, October 10, 1979.
McCallum, Bennett T. “Robustness Properties of a Rule for Monetary Policy.” Carnegie-Rochester Conference Series on
Public Policy, 1988, 29, pp. 173-203.
Melton, William C. Inside the Fed: Making Monetary Policy. Homewood, IL: Dow Jones-Irwin, 1985.
Meltzer, Allan H. “Limits of Short-Run Stabilization Policy.” Economic Inquiry, 1987, 25, pp. 1-14.
Meyer, Laurence H. A Term at the Fed: An Insider’s View. New York: HarperCollins, 2004.
Orphanides, Athanasios. “Monetary Policy Rules and the Great Inflation.” American Economic Review, May 2002, 92(2),
pp. 115-20.
Orphanides, Athanasios. “The Quest for Prosperity without Inflation.” Journal of Monetary Economics, April 2003a,
50(3), pp. 633-63.
Orphanides, Athanasios. “Historical Monetary Policy Analysis and the Taylor Rule.” Journal of Monetary Economics, July
2003b, 50(5), pp. 983-1022.
Federal Reserve Bank of St. Louis REVIEW
November/December 2013
539
Lindsey, Orphanides, Rasche
Orphanides, Athanasios. “Monetary Policy Rules, Macroeconomic Stability and Inflation: A View from the Trenches.”
Journal of Money, Credit, and Banking, April 2004, 36(2), pp. 151-75.
Orphanides, Athanasios and van Norden, Simon. “The Reliability of Inflation Forecasts Based on Output Gaps in Real
Time.” Working Paper 2003-01, CIRANO, January 2003.
Orphanides, Athanasios and Williams, John C. “The Decline in Activist Stabilization Policy: Natural Rate Misperceptions,
Learning and Expectations.” Working Paper 337, European Central Bank, April 2004.
Rasche, Robert H.; Meltzer, Allan H; Sternlight, Peter D. and Axilrod, Stephen H. “Money, Credit and Banking Debate: Is
the Federal Reserve’s Monetary Control Procedure Misdirected?” Journal of Money, Credit, and Banking, February
1982, 14(1), pp. 119-47.
Shadow Open Market Committee. Policy Statement. February 4, 1980.
Sivesind, Charles and Hurley, Kevin. “Choosing an Operating Target for Monetary Policy.” Quarterly Journal of Economics,
February 1980, pp. 199-203.
Taylor, John B. “Discretion versus Policy Rules in Practice.” Carnegie-Rochester Conference Series on Public Policy,
December 1993, 39, pp. 195-214.
Taylor, John B., ed. Monetary Policy Rules. Chicago: University of Chicago Press, 1999.
Tinsley, P.A.; von zur Muehlen, P. and Fries, G. “The Short-Run Volatility of Money Stock Targeting.” Journal of Monetary
Economics, September 1982, 10(2), pp. 215-37.
Tobin, James. “On Consequences and Criticisms of Monetary Targeting, or Monetary Targeting: Dead at Last?:
Comment.” Journal of Money, Credit, and Banking, November 1985, 17(4 Part 2), pp. 605-09.
Treaster, Joseph B. Paul Volcker: The Making of a Financial Legend. Hoboken, NJ: John Wiley & Sons, 2004, pp. 61-62.
U.S. Congress Joint Economic Committee. Domestic and International Implications of the Federal Reserve’s New Policy
Actions. Hearings before the Subcommittee on International International, November 5, 1979. Washington, DC:
Government Printing Office, 1980.
U.S. House of Representatives. “The New Federal Reserve Technical Procedures for Controlling Money,” in Measurement
and Control of the Money Supply. Hearings before the Subcommittee on Domestic Monetary Policy, March 20 & 25,
1980. Washington, DC: Government Printing Office, 1980a.
U.S. House of Representatives. Conduct of Monetary Policy. Transcript. Committee on Banking, Finance and Urban
Affairs. Washington, DC: Government Printing Office, February 18, 1980b.
U.S. House of Representatives. “Monetary Policy for 1980.” Third Report by the Committee on Banking, Finance and
Urban Affairs. House Report No. 96-881. Washington, DC: Government Printing Office, April 15, 1980c.
U.S. Senate. Nomination of Paul A. Volcker. Hearings before the Committee on Banking, Housing, and Urban Affairs.
Washington, DC: Government Printing Office, 1979.
U.S. Senate. “Federal Reserve’s First Monetary Policy Report for 1980.” Hearings before the Committee on Banking,
Housing, and Urban Affairs. Washington, DC: Government Printing Office, February 25, 1980.
Volcker, Paul A. “The Contributions and Limitations of ‘Monetary’ Analysis.” Remarks before the American Economic
Association and the American Finance Association, September 16, 1976 (reprinted in Federal Reserve Bank of New
York Monthly Review, October 1976).
Volcker, Paul A. The Rediscovery of the Business Cycle. London: Free Press, 1978.
Volcker, Paul A. “A Time of Testing.” Remarks before the American Bankers Association, October 9, 1979a.
Volcker, Paul A. Statement. Joint Economic Committee, U.S. Congress. Washington, DC: Government Printing Office,
October 17, 1979b.
Volcker, Paul A. Remarks before the National Press Club, January 2, 1980a.
Volcker, Paul A. Prepared statement. Hearings before the Joint Economic Committee, U.S. Congress. Washington, DC:
Government Printing Office, February 1, 1980b.
540
November/December 2013
Federal Reserve Bank of St. Louis REVIEW
Centennial Issue
Volcker, Paul A. Statement. Committee on Banking, Housing, and Urban Affairs, U.S. Senate. Washington, DC:
Government Printing Office, February 4, 1980c.
Volcker, Paul A. Statement. Committee on Banking, Finance and Urban Affairs, House of Representatives. Washington,
DC: Government Printing Office, February 19, 1980d.
Volcker, Paul A. Remarks, “Economic Outlook for the 80s.” January 15, 1980 (reprinted in Texas Business Executive,
Summer 1980e).
Volcker, Paul A. Statement. Subcommittee on Domestic Monetary Policy of the Committee on Banking, Finance and
Urban Affairs, House of Representatives. Washington, DC: Government Printing Office, November 19, 1980f.
Volcker, Paul A. Statement. Committee on Banking, Housing, and Urban Affairs, U.S. Senate. Washington, DC:
Government Printing Office, February 25, 1981.
Volcker, Paul A. “Can We Survive Prosperity?” Remarks before the Joint Meeting of the American Economic Association
and the American Finance Association, San Francisco, December 28, 1983.
Volcker, Paul A. and Gyohten, Toyoo. Changing Fortunes: The World’s Money and the Threat to American Leadership.
New York: Times Books, 1992.
Wallich, Henry C. “Techniques of Monetary Policy.” Remarks before the Missouri Valley Economic Association, March 1,
1980.
Wallich, Henry C. and Keir, Peter. “The Role of Operating Guides in U. S. Monetary Policy: A Historical Review.” Federal
Reserve Bulletin, September 1979.
Wall Street Journal. “Quotes for Gold Continue Surging on New Rumors.” September 18, 1979a, p. 3.
Wall Street Journal. “Fed, in a 4-3 Vote, Tightens Credit Reins By Lifting Discount Rate to Record 11%.” September 19,
1979b, p. 2.
Wall Street Journal. “Gold’s Price Surges $24 an Ounce At London, Hits a Record $375.75.” September 19, 1979c, p. 8.
Wall Street Journal. “Gold Price Falls, Partly Recovers in Later Trading.” September 20, 1979d, p. 2.
Wall Street Journal. “Fed Indicates It Wants Credit to Get Tighter.” September 20, 1979e, p. 5.
Wall Street Journal. “Rumors Send Prices in Gold, Other Markets into Day-Long Chaos.” October 3, 1979f, p. 1.
Wall Street Journal. “Monetary Medicine: Fed’s ‘Cure’ Is Likely to Hurt in Short Run by Depressing Economy, Analysts
Say.” October 9, 1979g, pp. 1, 6.
Wall Street Journal. “New York Fed Seeks to Lessen Confusion on Monetary Moves.” October 10, 1979h, p 3.
Federal Reserve Bank of St. Louis REVIEW
November/December 2013
541
542
November/December 2013
Federal Reserve Bank of St. Louis REVIEW
Centennial Issue
Inflation Targeting in a
St. Louis Model of the 21st Century
Robert G. King and Alexander L. Wolman
This article first appeared in the May/June 1996 issue of Review.
Federal Reserve Bank of St. Louis Review, November/December 2013, 95(6), pp. 543-73.
he St. Louis model of the early 1970s, as described by Andersen and Carlson (1972),
was a small-scale monetarist model of economic activity. Its structure was sharply at
variance with the framework of the major, larger scale macroeconometric models used
for policy analysis by the Federal Reserve, both at the time of the inception of the St. Louis
model and today.
The St. Louis model had four major features:
T
• It was sufficiently small that one could actually understand how it worked by looking at
the model’s behavioral equations and by conducting simulations of it.
• It could be used for policy analysis, specifically for studying the effects of monetary and
fiscal policy on inflation, output, and interest rates.
• The monetarist background of its authors meant that the model (1) focused on the quantity of money as the key measure of the stance of monetary policy and (2) contained structural linkages from money to economic activity that are now widely accepted, including
the central role of a long-run demand for money that is a relatively stable function of a
small number of variables.
• It combined short-run non-neutrality of changes in money with long-run neutrality, in
line with the perspective of Friedman and Schwartz (1963a and b).
At the time this article was written, Robert G. King was A. W. Robertson professor of economics at the University of Virginia. Alexander L. Wolman
was with the Federal Reserve Bank of Richmond. The authors had thanked Marianne Baxter, Michael Dotsey, Marvin Goodfriend, and Peter Ireland
for useful discussions during the preparation of this article and received valuable comments during various presentations of it, particularly from
Ben Bernanke, Michael Kiley, Preston McAfee, Edward Prescott, Julio Rotemberg, Christopher Sims, Mark Watson, and Michael Woodford.
This article has been reformatted since its original publication in Review: King, Robert G. and Wolman, Alexander L. “Inflation Targeting in a St. Louis
Model of the 21st Century.” Federal Reserve Bank of St. Louis Review, May/June 1996, 78(3), pp. 83-107;
http://research.stlouisfed.org/publications/review/96/05/9605rk.pdf.
© 2013, The Federal Reserve Bank of St. Louis. The views expressed in this article are those of the author(s) and do not necessarily reflect the views
of the Federal Reserve System, the Board of Governors, or the regional Federal Reserve Banks. 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.
Federal Reserve Bank of St. Louis REVIEW
November/December 2013
543
King and Wolman
With Lucas’s (1976) critique of policy evaluation, the St. Louis model was largely abandoned
by monetarists. The model fell victim to the critique in a particularly rapid and complete manner
because its builders had stressed that it contained quantitatively important effects of expectations.1
In this article, we construct a small-scale modern macroeconomic model that can be used
to study the effects of alternative monetary and fiscal policies in a manner consistent with Lucas’s
recommendations. That is, we build a rational expectations macroeconomic model in which
the intertemporal optimization problems of households and firms are explicitly described. We
call this a St. Louis model of the 21st century because we believe it is the type of small-scale
macroeconomic model that will be systematically employed for the purpose of policy analysis
by central banks in the coming years. The model is monetarist in five specific ways that it shares
with the St. Louis model:
• Our model contains a stable demand for money that is invariant to alternative monetary
policies.
• It incorporates short-run non-neutrality of money with long-run neutrality.
• Frictions in the price-setting process yield a short-run non-neutrality of money that is
quantitatively and economically important.
• Once one takes into account anticipated price change, these frictions lead to no quantitatively important long-run trade-off between inflation and real activity.
• Our model places a central emphasis on expectations in consumption choices, investment
decisions, asset valuation, and price determination in the tradition of Irving Fisher and
Milton Friedman.
We use this model to study an important question in monetary economics that is currently
policy-relevant at central banks around the world: What are the consequences of adopting an
inflation-targeting rule for monetary policy? We provide detailed information on two versions
of this question. First, since most central banks seek to target rates of inflation that are low by
the historical standards of their countries, we ask, What are the benefits (or costs) of having a
low rate of inflation? Second, since critics of inflation targets are frequently concerned that these
may interfere with stabilization policy, we ask, In a setting with sticky prices and demanddetermined output, how do the responses of the economy to various shocks differ from those
which would occur if prices were flexible?
Our model’s answers to these questions are very monetarist. First, there are major benefits
to setting low rates of inflation. That is, Friedman’s prescription for long-run monetary policy
(setting the nominal interest rate to zero) approximately holds in the long run of our model
economy even though we have some imperfect market “frictions” of the form stressed by Tobin
(1972a and b). Even if one does not go all the way to a zero nominal interest rate, there are quantitatively important long-run welfare gains from moving from an inflation rate of 5 percent to
price stability (0 percent inflation). Second, under a regime of perfect inflation targeting (in which
the path of the price level is specified exactly by the monetary authority), we find that the responses
of our sticky price model are essentially identical to those of a flexible price economy.
Our analysis thus suggests that there are major benefits to implementing an inflation-targeting
regime with a low target rate of inflation. To further explore issues that arise in the implementa544
November/December 2013
Federal Reserve Bank of St. Louis REVIEW
Centennial Issue
tion of this regime, we consider (1) the dynamic behavior of the economy if a target path for the
price level is implemented with an interest rate rule and (2) the dynamic behavior of real activity
if a credible, low inflation path is implemented immediately. We find that it is indeed feasible to
implement a policy of targeting the path of the price level with an interest rate rule. We also find
that there is zero cost of immediately introducing a credible low inflation program.
THE ST. LOUIS MODEL CIRCA 1972
The St. Louis model of macroeconomic activity was a small macroeconometric model containing five structural equations, as spelled out in Andersen and Carlson (1972): a total spending
equation, a price equation, a long-term interest rate equation, a definition of anticipated price
changes based on the long-term interest rate equation, and an Okun’s law (1962) link between
an output gap and unemployment. In addition, in the background, there were methods of measuring the trend level of real economic activity and the normal level of unemployment.
Money Demand and Expenditure
The centerpiece of the St. Louis model was a total spending equation, put forward in
Andersen and Jordan (1968), that linked the change in nominal gross national product to fourquarter distributed lags of changes in the nominal money stock and of high-employment federal
government expenditures. Given that the effects of high-employment expenditures were small,
this specification was widely viewed as resulting from a monetarist specification of the demand
for money—one with an income elasticity of unity and an interest rate elasticity of zero.
In the macroeconometric model, this specification was the econometric embodiment of the
Friedman and Schwartz (1963a and b) method of taking nominal income as proximately exogenous. It could be employed to discuss the effect of monetary changes on nominal income, as in
Andersen and Jordan (1968), without discussing the division of nominal income into price level
and real output.
Price Adjustment
As elaborated in Andersen and Carlson (1972), the St. Louis model employed a price equation to describe the division of nominal income into prices and output. That specification related
the change in the price level to two factors. First, anticipated changes in prices entered with a
coefficient of 0.86, so that the price equation was taken to be importantly influenced by the beliefs
of price setters. Second, a four-quarter distributed lag of changes in nominal income was included
as a measure of demand pressure in the macroeconomy.
The builders of the St. Louis model contrasted their approach with the approach used to
construct traditional price equations, such as those presented by Eckstein and Fromm (1968).
Those who built the St. Louis model emphasized that their tractable specification included important expectations effects and permitted the simultaneous determination of prices and output.
This latter feature was sufficiently novel, relative to the standard econometric practice of relating
price changes to real demand pressure measures, that it warranted extensive discussion by Tobin
Federal Reserve Bank of St. Louis REVIEW
November/December 2013
545
King and Wolman
(1972a and b) in his summary of the conference that led to the Eckstein (1972) volume. Since
the coefficients on the nominal demand variables summed to 0.10, the model also implied a
Phillips curve—defined by Andersen and Carlson (1972) to be the joint time paths of unemployment and inflation arising from their model, which involved only a very small effect of sustained
inflation on real activity. This small trade-off is contrasted with other contemporary studies such
as de Menil and Enzler (1972), Klein (1972), Bodkin (1972), and Eckstein and Wyss (1972).
Expectations
An unusual feature of the St. Louis model was its modeling of expectations. Andersen and
Carlson (1972) stressed that expected prices played a key role in the model and that their explicit
specification of an expectations mechanism allowed them to explore the trade-off between
inflation and unemployment at various horizons. They used the long-term interest rate as an
important empirical indicator of expected inflation and, for this reason, also included a structural
equation determining the long-term interest rate. The details of their expectations scheme were
sharply criticized by Gordon (1972) on theoretical and empirical grounds, although many practical macroeconomists now routinely use the long-term nominal interest rate as a guide to longterm inflation expectations.
A ST. LOUIS MODEL OF THE 21ST CENTURY
Many of the structural equations of our model economy are obtained by studying the optimization problems of households and firms. In addition, the structural equations include resource
constraints and the policy rule of the central bank.
Monetary Services and the Demand for Money
In our model economy, there is a well-defined demand for money that one can determine
from a problem of cost minimization. That is, one can define a demand for money conditional
on a pattern of expenditure determined as part of a more general utility maximization problem.
The demand for money stems from a transactions technology—a “shopping time technology”
in the terminology of McCallum and Goodfriend (1987)—which governs the amount of time
that must be spent to undertake real consumption activity within the period t of our discrete time
setup. This shopping time function specifies that time devoted to transactions activity depends
negatively on the ratio of the amount of real money balances (mt) to the amount of real consumption expenditure (ct ):
(1)
m
ht = h t .
ct
Throughout, we use notation in which lowercase letters refer to real variables and uppercase
letters refer to nominal variables so that mt is the quantity of real balances and is equal to Mt /Pt ,
where Mt is the stock of money held during the period and Pt is the price level.
546
November/December 2013
Federal Reserve Bank of St. Louis REVIEW
Centennial Issue
The opportunity cost of a unit of time spent shopping is given by the real wage rate. The
opportunity cost of choosing to hold a unit of money during period t is the discounted value of
interest forgone next period, so that the rental price of a unit of cash balances is
Rt 2
.
1 + Rt
Minimizing the flow real cost
w t ht +
Rt
mt ,
1 + Rt
through selection of the quantity of real balances accordingly requires that
(2)
m 1
R
−wt Dh t = t ,
ct ct 1 + Rt
which implicitly defines the demand for money. In this expression,
m
−Dh t ,
ct
is the marginal time saving that arises from holding an additional unit of cash balances per unit
of consumption expenditure. (We use Dh to denote the derivative of the h function with respect
to the ratio m/c, viewing it as a function of this single variable.) In our theoretical analysis, we
assume that this time saving is diminishing in the ratio (m/c). Our empirical work justifies this
assumption.
Notice that if the real wage and real consumption grow at the same rate and the nominal
interest rate is constant over time, then our specification implies that there is constant “consumption velocity.” That is, there is no trend in the ratio m/c. In our empirical analysis below, we
specify that the function
m
Dh t ,
ct
takes a specific parametric form
m
m
Dh t = κ − t / ζ
ct
ct
−
1
v
,
which then implies that
−v
(3)
mt
R c
= ζ κ + t t .
ct 1 + Rt wt
This functional form for real money demand per unit of expenditure is close to the constant
elasticity structure that is frequently studied in the literature. Notably, if k = 0, then there is a
loglinear money demand function,
Federal Reserve Bank of St. Louis REVIEW
November/December 2013
547
King and Wolman
log (mt ) = log (ζ ) + (1 − v ) log (ct ) − vlog
Rt
+ v log (w t ) .
1 + Rt
More generally, the parameter k allows there to be a finite “satiation” level of real cash balances,
m = z [k ]–vc, which occurs as a limiting case when the nominal interest rate is zero. We choose
this parametric form for the Dh(mt /ct ) function because we want to generate a demand for money
that is relatively conventional, while leaving open the issue of whether there is a finite satiation
level of cash balances.
Consumption Demand and Labor Supply
Intertemporal utility maximization leads to demand for consumption (ct ) and supply of
labor (nt ), given the allocation of time to shopping (ht ) discussed above. Expected date t lifetime
utility is given by
∞
EtU t = Et ∑ β ju (ct+ j ,lt + j ) ,
j =0
where the momentary utility function implies that both consumption and leisure (lt ) are goods.
Later in the analysis we adopt a parametric specification of this function that has been much
used in the real business cycle literature.
Individuals choose contingency plans for consumption, labor supply, real balances, shopping
time, and leisure to maximize expected utility subject to a present value budget constraint that
links income and expenditure,
∞
∞
Rt + j
Et ∑ ∆t , j Pt + j ct + j ≤ Et ∑ ∆t , j Pt + j × wt + j = nt+ j −
mt + j + other wealth,
1 + Rt + j
j =0
j =0
as well as a time constraint that restricts work, shopping time, and leisure,
(4)
nt + j + lt + j + ht + j = 1.
In addition, as discussed above, there is a technology linking shopping time to current
expenditure, ct and real cash balances, mt . Since these specifications are standard, we will review
them relatively briefly. First, in the present value budget constraint, we are discounting nominal
cash flows at date t+j by the discount factor Dt,j .3 Second, also in this expression, we have real
prices of work and cash balance holding: wt is the real wage (Wt /Pt where Wt is the nominal wage)
and the rental price of a unit of real cash is Rt /(1 + Rt ), as discussed above. Third, the time constraint includes time spent “shopping,” as well as at working and at leisure: Market work is a residual given determination of leisure demand from utility maximization and time spent shopping
from cost minimization.
Maximization of utility subject to these constraints leads to the following efficiency conditions for consumption, leisure, and money balances. These efficiency conditions are structural
equations of our small-scale macroeconomic model. Since they contain expectations, they must
548
November/December 2013
Federal Reserve Bank of St. Louis REVIEW
Centennial Issue
be evaluated as part of a complete rational expectations solution, but presentation of them provides us with the opportunity to describe the main implications that they have, taking expectations as exogenous. First, the efficient selection of consumption requires
(5)
mt+ j mt + j
2 ,
Et β j D1u ( ct + j ,lt + j ) = Λ t Et ∆t , j Pt + j 1 − w t+ j Dh
c
t + j ct + j
for j = 0,1, . . . Second, the efficient selection of labor requires
(6)
Et β j D2u (ct+ j ,lt + j ) = Λ t Et ∆t , j Pt+ j wt + j ,
for j = 0,1, . . . Third, the efficient pattern for cash balance holdings requires that
m 1
R
t+ j
= t+ j ,
−wt + j Dh
ct + j ct + j 1 + Rt + j
for j = 0,1, . . . In these expressions Lt is the Lagrange multiplier on the wealth constraint and
thus represents the lifetime utility gain from an additional dollar of wealth at t. We use the notation Diu to denote the partial derivative of the utility function with respect to its ith argument.
In the first of these efficiency conditions, notice that the shopping time technology means
that the Beckerian “full price” of a unit of consumption at date t+j involves a time cost of shopping,
m m
t+ j
2t + j ,
∆t , j Pt + j −w t+ j Dh
c
t + j ct + j
as well as the standard market cost component Dt,j Pt+j . In the second, notice that there is the
standard equating of the costs and benefits of forgoing a unit of leisure and supplying it to the
marketplace. Together with the lifetime budget constraint, these two equations implicitly determine consumption and leisure demand at all dates in line with a “permanent income” approach
to these two actions. The third condition is the “money demand” cost minimization condition
discussed above.
Labor Demand, Investment, and Marginal Cost
As in Rotemberg (1987) and Blanchard and Kiyotaki (1987), we assume that firms have some
market power, behaving as monopolistic competitors. (We contrast this to a perfect competition
situation in some places below.) In this subsection, we focus on the structural equations arising
from the representative firm’s decision problem that concern production, labor, and investment
demand. In the next subsection, we focus on pricing implications. It is accordingly useful to
think about breaking the firm into three separate parts for planning purposes.
First, the production unit takes as given the output level of the firm and the rental price of
capital (a transfer price from the investment unit): It determines labor demand and capital
demand so as to minimize cost. Second, the investment unit takes as given the market prices of
investment goods and the rental price of capital: It determines investment so as to maximize the
Federal Reserve Bank of St. Louis REVIEW
November/December 2013
549
King and Wolman
value of the firm. The activities of these two units are explored in this section. Third, the pricing
unit determines the price of the firm’s output, taking into account demand conditions and costs.
Throughout, the firm is taken to maximize the expected present value of its profits,
∞
EtVt = Et ∑ ∆t , j Pt+ j yt + j −Wt + jnt + j − Pt+ j it + j ,
j=0
subject to the production technology for its final product,
yt + j = at+ j f (nt + j ,kt+ j ) ,
(7)
and the evolution equation for its capital,
kt + j+1 − kt + j = φ (it + j kt + j ) kt+ j − δ kt + j ,
(8)
where f (i/k) is a positive, increasing and concave function that embodies costs of adjustment
for the capital stock.
To describe decisions of the production unit, we employ standard microeconomic conditions
for cost minimization. For this purpose, we assume that the output level is given at any arbitrary
level ŷt+j and that capital can be rented at price Zt . Then, the static conditions for cost minimization are:
Ψ t + j at + j D1 f (nt + j ,kt+ j ) = Wt + j ,
(9)
and
Ψ t + j at + j D2 f (nt + j ,kt + j ) = Zt + j ,
(10)
where Yt+j is the Lagrange multiplier on the constraint yt+j = ŷt+j and Yt+j accordingly is interpretable as nominal marginal cost. The conventional solution to this problem implies that marginal cost is a function of the level of output; the productivity shifter, at+j ; and the factor prices,
Wt+j and Zt+j . It also depends on the form of the production function: We assume that the production function (equation 7) is constant returns-to-scale, so that marginal cost is independent
of output and thus write Yt+j = Y(at+j , Wt+j , Zt+j ).
In terms of the decisions of the investment unit, we assume that the firm chooses the optimal
investment pattern to maximize its present discounted value given the rental price Zt+j . This
leads to a pair of efficiency conditions,
Pt = Qt Dφ (it kt ) ,
(11)
and
(12)
550
i i
i
Qt = Et ∆t ,1 Zt +1 + φ t +1 − t +1 × Dφ t+1 +1 − δ ∆t ,1Qt +1 .
kt+1
kt+1 kt +1
November/December 2013
Federal Reserve Bank of St. Louis REVIEW
Centennial Issue
In accord with the investment technology that Hayashi (1982) and others have used to rationalize a Tobin’s q-theory of investment, the first of these specifications indicates that the investment
rate it /kt is determined by the ratio of the (shadow) price of installed capital (Qt ) to the price of
replacement capital (Pt ), that is, it is a function of the ratio q = Q/P. The evolution of Qt over time
takes into account the discounted value of rentals accruing in the future period, as well as the
effect of capital accumulation on next period’s capital stock and adjustment costs.4
Price Setting
The price-setting structure that we employ follows Calvo (1983), in ways that are recommended by Rotemberg (1987) and are similar to the recent work of Yun (1996). Firms are assumed
to be able to change their prices only in specific states of nature and must otherwise satisfy all
demand at the quoted price. As we will see, this latter requirement—that we treat as one of the
institutions of the marketplace—has important consequences for optimal price setting.
The price-adjustment event occurs with probability 1–h so that with probability h the firm
is stuck with a predetermined nominal price. Accordingly, the expected time of price fixity is
(1 − η )1 +η (1 −η ) 2 +…+η n−1 (1 − η )η +… ,
which is equal to (1–h)–1. We assume that the average firm adjusts its price every four quarters
(once per year) so that h = 0.75, but we also experiment with higher values. The stochastic pricesetting specification also implies a (stationary) distribution of firms in terms of the time that they
last adjusted their price. The fraction of firms that last adjusted price j periods ago, qj , is given
by qj = (1–h)h j.
This price-setting specification captures two key features of price setting that have been much
emphasized by macroeconomists working on price adjustment: The timing and magnitude of
price adjustments vary widely across firms in ways that appear stochastic to an outside observer.
However, given that the probability of price adjustment h is exogenous in the Calvo setting, the
frequency of price adjustment cannot adjust to variations in the state of the economy: It cannot
change either with the average rate of inflation or with the stage of the business cycle.5
We assume that firms are monopolistic competitors and that each faces a date t demand
schedule of the form
(13)
y dj ,t = dt ( Pt*− j Pt ) ,
−ε
* .6 In this expression, d is a
if it last adjusted its price j periods ago and selected the price Pt–j
t
demand shifter that depends on the state of the economy and Pt is the aggregate price level that
evolves according to
1
(14)
(1−ε ) 1−ε
∞
*
Pt = ∑θ j ( Pt − j )
.
j=0
Using the stationary fractions given above, the dynamics of the aggregate price level Pt can be
reduced to
Federal Reserve Bank of St. Louis REVIEW
November/December 2013
551
King and Wolman
1
(15)
(1−ε )
(1−ε ) 1−ε
Pt = (1 −η ) ( Pt* ) + η ( Pt −1 )
,
where h(Pt–1)(1–e) represents the influence of the prices charged by the fraction of firms that do
not currently change prices in period t and (1–h)(Pt*)(1–e) represents the influence of the firms
that do change prices in period t.
In this time-dependent price-adjustment framework, a firm that is rationally setting its price
in period t will choose to equate marginal revenue and marginal cost in a discounted, expected
value sense. Dynamic marginal revenue stemming from a change in the price is given by
∞
Et ∑ ∆t , jn j (1 − ε ) y dj ,t + j .
j =0
The form of this expression reflects the fact that the price at t+j will remain at the chosen
level Pt* with probability n j. Similarly, the dynamic marginal cost associated with a price change is
∞
−1
Et ∑ ∆t , jη j ( −ε ) Ψ t+ j ( Pt* ) y dj ,t + j .
j =0
We can simplify these expressions as in the standard static case and then equate dynamic marginal cost and revenue to obtain a price that it is optimal to charge:
∞
(16)
Pt* =
ε
ε −1
Et ∑ ∆t , jη j Ψt + j dt + j Pt + j
j=0
∞
Et ∑ ∆t , jη d P
j
.
ε
t+ j t+ j .
j=0
Three implications of this expression are worth elucidating. First, if marginal cost were
constant over time at the level Y, then we obtain
P* =
ε
Ψ,
ε −1
so that the ratio
µ=
ε
,
ε −1
is interpretable as the markup just as in the static case. Second, in the dynamic setting, price setting is influenced by the scale of output (demand) unless the entire sequence of outputs in the
numerator and denominator expressions are scaled by a common factor. Third, optimal price
setting in the Calvo environment involves forecasting both demand and costs.
Taking the price-setting rule (equation 16) and the price index (equation 15) together, it is
clear that there is long-run homogeneity of nominal prices in terms of nominal costs:
P = P* =
552
November/December 2013
W
ε
ε
Ψ=
.
ε −1
ε − 1 aD1 f (n,k )
Federal Reserve Bank of St. Louis REVIEW
Centennial Issue
Accordingly, as all of the other behavioral equations of our model are written in real terms,
it follows that our model will display long-run neutrality of money: Permanent changes in the
quantity of M will ultimately affect prices and not output, even with short-run rigidity of prices.
However, there will be a departure from superneutrality, in that the same frictions that lead to
(1) the demand for money and (2) the short-run rigidity of prices will mean that there will be
real effects of sustained inflation. In the next section we quantify these real effects.
The Marginal and Average Markup
Given that firms are charging different prices in our setting, it is clear that there will be different values of markups across firms. We define the marginal markup as that earned by firms
which are currently adjusting price, that is,
µt* = Pt* Ψ t .
We define the average markup as the ratio of the aggregate price level to marginal cost, that is,
µt = Pt Ψ t .
In a steady state with zero inflation, both of these constructions are equal to the static markup
ε
,
ε −1
but in steady states with inflation or deflation, there will no longer be this equality. Similarly, in
response to business fluctuations, the fact that part of the price level is predetermined will lead
to different time-series variation in the marginal and average markup.
µ=
OPTIMAL INFLATION POLICY IN THE LONG RUN
A natural method for determining the target rate of inflation is to choose that rate of inflation
which maximizes the welfare of the representative household. In this section we conduct such
an analysis for the “long run,” defined as a steady-state situation in which all variables grow at
constant rates in ways that are consistent with the model economy outlined in the previous section. We solve the equations of the model for the link between inflation and welfare, isolating
the factors that are important for determining the long-run optimal inflation policy.
In models with perfect competition and continuously adjusted prices, there is a presumption
that the optimal inflation policy is that which makes the private cost of holding money equal to
the social cost of production, that is, a nominal interest rate of zero. Given a positive real interest
rate, this condition represents a prescription for long-run deflation policy that was first made by
Milton Friedman (1969). Friedman’s conclusion has been replicated in a wide range of theoretical
environments.
In particular, letting the rate of inflation be p and the level of the real interest rate be r, it
follows that the definition (1 + R) = (1 + r)(1 + p ) and the Friedman rule condition R = 0 together
imply that the optimal rate of inflation should be
Federal Reserve Bank of St. Louis REVIEW
November/December 2013
553
King and Wolman
Figure 1
Time Cost of Inflation
A. Actual and Estimated Demand for Money
B. Time Saved
Hours per Quarter
(c/w)(R/(1 + R))
8
0.004
6
4
0.003
2
0.002
0
–2
0.001
0.000
0.4
–4
0.8
1.2
1.6
2.0
2.4
2.8
3.2
–6
–2
3.6
0
2
4
6
8
10
12
Percent Annual Inflation
m/c
π f =−
r
1+ r ,
where the superscript indicates that this is the Friedman rule level of the inflation rate. Long-term
U.S. data compiled by Ibbotson and Sinquefeld (1982) indicate that the average real return on
Treasury bills is between 0 percent and 1 percent so that this represents a recommendation for
at most a small deflation.
Estimating the Welfare Gains from Lower Inflation
One measure of the gains from lower inflation may be computed as the time savings generated as agents increase their cash balances, gains that are sometimes viewed as small. Following
the provocative work of Lucas (1993), there has been much recent interest in the magnitudes of
these gains. In this article, we use a benchmark estimate from Wolman (1996), the nature of
which is displayed in Figure 1.
In the first step, the three-parameter money-demand function (equation 3) is fit to annual
U.S. time-series data over the 1915-92 period. Each annual observation on the pair of ratios, m/c
and (c/w)(R/(1 + R)), enters as a dot in the left panel of Figure 1.7 The representative individual
holds cash balances equal to 1.62 quarters of consumption expenditure at the sample mean
(denoted by a “+” in the left panel of Figure 1). The values of z, k, and n are chosen to provide a
best fit in a least squares sense, and the solid line in the left panel traces out the fitted relationship.
As it turns out, the estimates indicate a satiation level of real cash balances. Cash balances equal
2.7 quarters of consumption expenditure at the estimated satiation level, which is somewhat smaller
than the maximum cash balances in the sample (about 3.3 quarters of consumption expenditure).
In the second step, we compute the time savings that arise as the inflation rate is lowered
from a benchmark level of 5 percent per year. For this purpose, we employ the estimated param554
November/December 2013
Federal Reserve Bank of St. Louis REVIEW
Centennial Issue
eter values obtained in the first step and also the sample average value of c/w over 1915-92. That
is, given the parameters, the marginal time savings at any level of real balances is
1
m − v
mt
Dh = κ − t / ζ .
ct
ct
Substituting in the formula for the real demand for money from equation 3 and assuming that
the real interest rate is invariant to inflation, we can then determine the time savings of moving
from one inflation rate to another, which is the integral of such time savings over the relevant
range. The right panel of Figure 1 is the result of this computation. We find that a movement
from a 5 percent rate of inflation to a 0 percent rate of inflation would lead to a saving of about
5 hours per quarter. Adopting the Friedman rule from an initial position of 5 percent inflation
would lead to a saving of about 7 hours per quarter. For an individual working 40 hours per week
for 12 weeks in a quarter, these time savings represent about 1 percent of his time. Since the
average hours worked by an average work-age individual is lower, about 20 hours per week, it
follows that the time saving is roughly 2 percent.
The Markup and Inflation
In models with monopolistic competition and staggered price setting, economists have long
suggested that the Friedman rule is not desirable. One argument that is sometimes made for
departing from the Friedman rule is that the markup of price over marginal cost may depend
negatively on the inflation rate.8 Since higher levels of the markup depress economic activity
(acting like a tax on factor supplies), the deflation envisioned by Friedman would have social
costs, as well as social benefits. Thus, there is an open issue as to the level of the optimal rate of
inflation within setups such as ours.
The average markup of price over marginal cost that prevails in our economy depends on
two factors,
(17)
µt =
Pt Pt Pt*
= .
ψt Pt* ψt
These two factors are (1) the marginal markup (defined above as the ratio of price to marginal
cost for firms that are free to adjust their prices) and (2) the price adjustment gap (defined as
the ratio of the general price level to the price charged by firms that are free to adjust).
The price adjustment gap and inflation. In a steady-state situation, the price adjustment
gap is:
1
(18)
Pt
(1−ε )
1 −η
.
* =
(1−ε )
1
Pt
1−η
1+ π
This expression is obtained by evaluating equation 15 in a situation where Pt and Pt* are growing
at the rate p . If there is no inflation, then there is no price adjustment gap in the steady state—
Federal Reserve Bank of St. Louis REVIEW
November/December 2013
555
King and Wolman
Figure 2
Implications of the Price Adjustment Gap
A. Markup of Price over Marginal Cost
B. Output Compared with Baseline of 5 Percent Inflation
Markup
Output
10
8
1.40
1.36
6
4
1.32
2
1.28
0
–2
–4
1.24
1.20
–2
0
2
4
6
8
Percent Annual Inflation
10
12
–6
–2
0
2
4
6
8
10
12
Percent Annual Inflation
all firms are charging P*. At a higher rate of inflation, it follows that Pt is less than Pt*: A price
adjustment gap emerges. This gap reflects the fact that higher inflation mechanically erodes the
real value of markups and thus erodes relative prices set by firms in past periods.
We think of this price adjustment gap as a feature of sticky price models that is emphasized
by traditional econometric price equations such as those developed in Eckstein and Fromm
(1968). The implicit assumption in such studies is that firms set Pt* as a fixed markup over marginal cost Yt . With such an assumption, there is a substantial effect of a sustained inflation on
the markup and on macroeconomic activity (displayed in Figure 2). In the left panel, we display
the implications of equation 18 for the average markup. To construct this diagram, we assume
that there is a gross markup equal to 1.3 at zero inflation (so that the elasticity of demand e , is
4.33). We also assume that h = 0.75 (so that the average duration of price fixity is a year). Higher
rates of inflation erode the markup, which approaches zero at an annual rate of inflation of about
25 percent per year. Since the markup acts like a tax on real activity (as discussed in Blanchard
and Kiyotaki, 1987; Rotemberg and Woodford, 1991; and Goodfriend, 1995), declines in its level
are associated with the substantial increases in output shown in the right panel of Figure 2.
Concretely, if the price adjustment gap were the only structural feature of price dynamics,
then an increase in inflation from 5 percent to 10 percent would raise output permanently by
about 7 percent.
Effects of forward-looking price setting. In a situation of sustained inflation, however, our
model does not imply that price adjusting firms behave in the manner that underlies Figure 2.
In particular, the ratio of newly set prices to marginal cost—the marginal markup—is given by
(19)
556
−1
Pt* ε
1
1
γ
η
γ
η
+
+
(
)
(
)
× 1 −
.
1 −
=
1−ε
−ε
s
s
ψt ε − 1 (1 + r ) (1 + π ) (1+ r ) (1 + π )
November/December 2013
Federal Reserve Bank of St. Louis REVIEW
Centennial Issue
This expression is a steady-state version of equation 16 in which g is the real growth rate of the
economy, r s is the real interest rate appropriate for discounting the firm’s cash flows (given by
the real rate of interest on the stock market, about 6.5 percent), and
ε
ε −1
is the markup that would prevail in the absence of staggered price setting (that is, with h = 0).
The optimal pricing rule makes this ratio depend positively on the inflation rate. A higher expected
rate of inflation leads firms to set a higher price when they are free to adjust, principally because
they know that as long as their nominal price remains fixed, inflation will erode both their relative price and the real value of any markup established today. The former erosion means there is
increasing substitution toward a product as long as its price is fixed. The latter erosion means that
per-unit profits fall for as long as a price is fixed. Since firms must fill demand at posted prices,
they attempt to counter these two effects by setting higher markups in the face of higher inflation
rates.
The Approximate Optimality of the Friedman Rule
A striking feature of our setup is that the Friedman rule is approximately optimal under a
wide range of assumptions about the magnitude of price adjustment (h), the extent of the static
markup
ε
µ =
,
ε −1
and the specification of the transactions technology. By approximate optimality, we mean the
following. Since the transactions technology implies a satiation point for cash balances, at the
Friedman rule, there must be a zero loss to holding a slightly smaller amount of real cash balances.
Thus, if the markup can be reduced by slightly more inflation at the Friedman rule (as it can for
the parameters that we study), then there will be an unambiguous welfare gain to increasing
inflation from the Friedman rule.9 Although this point can be established formally, one needs a
microscopic inspection of the welfare trade-off to find it in the experiments reported below:
The maximum welfare point occurs very close to the Friedman rule.
The benchmark case. To begin, the top panel of Figure 3 shows the relationship between
welfare in the steady state and the rate of inflation for a benchmark case. In this benchmark case,
we assume that
η = 0.75, µ =
ε
= 1.3,
ε −1
and make other assumptions about the steady state of the model presented in Table 1. (These
other parameter assumptions are conventional in the quantitative business cycle literature.) The
reference point for our analysis is a situation of 5 percent inflation, indicated by * in Figure 3.
In models that abstract from variations in labor supply, a standard measure of welfare is the
fraction of steady-state consumption that an individual would give up to avoid a distortion (as
in Lucas, 1990). In our setting with variable labor supply, we use the measure of welfare depicted
Federal Reserve Bank of St. Louis REVIEW
November/December 2013
557
King and Wolman
Figure 3
Steady State Welfare
A. Welfare Compared with Baseline of 5 Percent Inflation
B. The Welfare Measure
Welfare
Consumption
1.2
0.5
0.8
0.4
0.4
0
0.3
–0.4
0.2
–0.8
–1.2
0.1
–1.6
–2.0
0
–2
0
2
4
6
8
Percent Annual Inflation
10
12
0
0.2
0.4
0.6
0.8
1.0
1.2
1.4
1.6
Leisure
graphically in the lower panel of Figure 3—the amount of additional consumption expenditure
that could be purchased by an individual at an initial relative price of consumption and leisure.10
Although we measure the change in full income along the vertical axis of the right panel of
Figure 3, valuing changes in leisure and consumption at a constant relative price, we express the
welfare effect as a fraction of measured national income, so it is directly comparable to other
measures of welfare losses expressed as a fraction of steady-state national income.
The salient features of Figure 3 are twofold. First, as the rate of inflation falls toward p f = –1
percent from the reference level of p = 5 percent there is a substantial increase in welfare. Fundamentally, this increase arises because there is a decrease in shopping time when the nominal
interest rate falls and the associated cost of money holding falls. Recent work by Lucas (1993)
has documented the magnitude of these welfare gains in economies simpler than those studied
in this article, namely ones that abstract from variable labor supply, physical capital accumulation,
and staggered price setting. He finds gains on the order of 1.5 percent of national product, a
useful benchmark for our discussion.
In our setting, the magnitude of the welfare gain to pursuing the Friedman rule is 1.1 percent
of national income. The gain to moving from 5 percent inflation to 0 percent inflation is about
0.8 percent of national income. Second, Figure 3 also shows that there are quantitatively important welfare losses from raising inflation from the benchmark level of 5 percent: An increase in
the inflation rate from 5 percent to 12 percent lowers welfare by 2 percent.
Interpretation. In Figure 1, there was a gain from lowering inflation since the society economized on transactions time. In Figure 2, there was a gain from raising inflation—inflation
eroded markups and lower markups stimulated economic activity. Given the magnitude of the
real effects in Figures 1 and 2, one would suspect a strong case for high inflation. Yet, when these
two forces are combined (as in Figure 3), there is a strong case for low inflation.
558
November/December 2013
Federal Reserve Bank of St. Louis REVIEW
Centennial Issue
Figure 4
Table 1
The Markup and Inflation
Parameters
Markup
1.40
1.36
1.32
e
Own price demand elasticity
4.33
h
Probability price does not change
0.75
z
Multiplicative term in h ( ) function
n
Curvature of h ( ) function
0.8004
k
Shift term in h ( ) function
0.0011
sn
Labor share
0.01156
⅔
d
Quarterly depreciation rate
1.28
x
Investment adj. cost parameter
–((i/k) (f¢¢/f¢ ))(–1)
1.24
g
Quarterly real growth rate (3 percent annually) 0.0074
p
Quarterly inflation rate (5 percent annually)
0.0122
b
Utility discount factor (quarterly)
0.9917
1.20
–2
0
2
4
6
8
10
12
0.025
2
Utility function: u(c,l) = ln(c) + 2.47 . ln(l)
Percent Annual Inflation
The main reason for this striking finding is that the experiment displayed in Figure 2 leaves
out the incentives firms have to change their price-setting behavior in a situation of sustained
inflation. That is, in our model, a situation of positive steady-state inflation involves two offsetting displacements relative to price stability. The first is that inflation opens a price adjustment
gap, lowering the average markup because
Pt
* < 1.
Pt
The second is that the marginal markup rises with inflation as firms seek to avoid an erosion
of their relative price and markup. Figure 4 contrasts the overall effect of inflation on the steadystate markup (dashed line) to the partial effect from Figure 2 that takes into account only the
price adjustment gap (solid line).
There are two distinct regimes. Over the range relevant for considering a decrease in inflation relative to the benchmark level of 5 percent, the average markup is relatively unaffected by
inflation: The incentives that firms have to raise the marginal markup are just offset by the decline
(via the price adjustment gap) in the average markup.11 For this reason, the welfare analysis of
inflation coincides with Friedman’s analysis. Over the range relevant for considering increases
in inflation relative to its benchmark level, significant increases occur in the average markup.
This response stems from an even larger effect on the marginal markup, that in turn reflects
sufficient demand response to the real price declines associated with inflation that firms choose
to increase the marginal markup dramatically to avoid the prospect of satisfying unprofitable
demand in the future.
Sensitivity analysis. We now present a brief sensitivity analysis. Six dimensions exist along
which it seems natural to explore the robustness of the relationship between welfare and inflation
depicted in Figure 4.
Federal Reserve Bank of St. Louis REVIEW
November/December 2013
559
King and Wolman
• How different is the size of the cost of inflation in our sticky price, monopolistically competitive setting from that in a flexible price, perfectly competitive setting?
• How would this cost be overestimated if one viewed price setters as myopic, in the same
way we did in constructing Figure 1 and as was frequently done in traditional Keynesian
macroeconometric models?
• How different would the costs of inflation be if the economy were much less competitive?
• How sensitive is the cost of inflation to higher values of h, that is, to more inertia in prices?
• How is the cost of inflation affected by eliminating the inflation distortion between consumption and leisure?
• How sensitive is the cost of inflation to our assumption that there is a satiation level of
real cash balances?
The six panels of Figure 5 display the answers to these questions. In each panel, we use the
dashed line to represent the results from the benchmark case and a solid line to represent those
from the case under study.
Variations in competition, price rigidity, and forward-looking behavior. In conducting
the first four alterations in the model, we assumed that the economies were each calibrated at a
5 percent inflation rate, so that the new and old lines all rotate through the 5 percent inflation
point. In panel A the effect of moving to perfect competition and flexible prices is shown: There
is minimal difference. In panel B we provide a case similar to that underlying Figure 2 in which
price setters are assumed not to be forward-looking: It is the single case we have found of a setting
in which there is a case for increased inflation (a very strong one). In panel C we see the effect
of raising the static markup from 1.3 to 3: The effect is to slightly increase the welfare benefit
from reducing inflation. The analysis of Goodfriend (1995) can be used to explain this result.
With less competition (higher m), the wage rate is a smaller fraction of labor’s marginal product
and output is correspondingly further below its efficient level. Thus, when labor flows out of
transactions activity and into productive activity, there is a larger welfare gain. In panel D we
see the effect of raising the expected duration of price setting from 4 quarters to 10 quarters,
that is, the effects of an increase in h from 0.75 to 0.8. There is little effect on the benefits from
lower inflation but a larger increase in costs of higher inflation.12
Variations in the money demand specification. In panel E we show the effect of eliminating
the implications that the money demand function has for the full price of consumption: We set
the term
mt + j mt + j
2 ,
w t+ j Dh
ct + j ct + j
to zero in the expression (equation 5) for optimal consumption. We view this as the traditional
neoclassical and monetarist procedure of ignoring the implications of the cost of money holding
for the full price of consumption—it is used, for example, in most textbooks with strong neoclassical underpinnings, such as Bailey (1971), Barro (1990), and Abel and Bernanke (1992).
However, this assumption is the polar opposite of that made in cash-in-advance models of money,
where the transactions technology implicitly makes variations in the ratio of consumption to
560
November/December 2013
Federal Reserve Bank of St. Louis REVIEW
Centennial Issue
Figure 5
Sensitivity Analysis
B. Price Adjustment Gap Only
A. Perfect Competition
Welfare
Welfare
1.2
0.4
–0.4
–1.2
–2.0
–2
4
6 8 10
0 2
Percent Annual Inflation
12
C. Static Markup = 3
4
6 8 10
0 2
Percent Annual Inflation
12
D. Stickier Prices
Welfare
1.6
1.2
0.8
0.4
0
–0.4
–0.8
–1.2
–1.6
–2.0
–2
2.5
2.0
1.5
1.0
0.5
0
–0.5
–1.0
–1.5
–2.0
–2
Welfare
2.0
0
–2.0
0
2
4
6
8
10
12
–4.0
–2
Percent Annual Inflation
0
2
4
6
8
10
12
Percent Annual Inflation
E. Full Price Effect
F. No Satiation Level of Real Balances
Welfare
Welfare
1.2
1.2
1.0
0.4
0.8
–0.4
0.6
–1.2
–2.0
–2
0.4
4
6
8 10
Percent Annual Inflation
0
2
12
0.2
–1.5
0.5
1.5
2.5
Percent Annual Inflation
–0.5
3.5
money infinitely expensive in terms of time. That is, in the cash-in-advance analysis of Cooley
and Hansen (1992), there is only a full price effect of inflation, not a time reallocation effect
associated with costly substitutions in transactions activities designed to avoid the inflation tax.
Panel E shows small differences in our cost of inflation measure for small rates of inflation, but
these become more pronounced as the inflation rate increases. Thus, the traditional neoclassical and monetarist procedure is a good approximation for small and moderate inflations, but it
would likely not be for hyperinflations. In panel F, we investigate the effect of ruling out satiation
in real balances (imposing the restriction k = 0 when estimating the money demand function).
Federal Reserve Bank of St. Louis REVIEW
November/December 2013
561
King and Wolman
Lucas (1993) imposes such an assumption that has the effect of making the Friedman rule exactly
rather than approximately optimal.13 However, in other ways it has little effect on our welfare
computations.
INFLATION TARGETING AND BUSINESS CYCLES
Having established that benefits to targeting a low rate of inflation exist in the long run, we
turn next to evaluating how a policy of inflation targeting influences the dynamic response of
our economy to various shocks. For this purpose, we use a perfect inflation targeting scheme in
which the central bank is presumed to manipulate the money supply each period so as to achieve
exactly the target rate of inflation (an annualized 5 percent rate of inflation in our experiments).
Then we ask how real activity responds to productivity and money demand shocks that we take
to be two major sources of disturbances. We model these as random walk shocks because we
think these are largely permanent in nature.
The motivation for this part of the investigation is to see what gains or losses would arise if
the central bank could target the inflation rate accurately. In particular, we are concerned with
whether price-level targeting introduces major gaps relative to the real outcomes that would arise
if there were perfect price flexibility. The bottom line is that it does not, according to both “eyeball” and formal welfare measures. In fact, compared with a policy of money supply targeting,
inflation targeting succeeds in eliminating these gaps. To understand this result, it is necessary
to understand how real activity responds to shocks under money supply targeting. Our analyses
of productivity and money demand shocks thus begin with this case. We subsequently discuss
how and why responses differ under inflation targeting.
Productivity Shocks
Figure 6 displays the impulse response functions to a permanent productivity shock of output, consumption, investment, hours, the average markup, the real wage, the real interest rate,
and real balances, assuming that the money growth rate is held constant.14 The dashed lines
describe a flexible price economy (h = 0), and the solid lines describe a sticky price economy
(h = 0.75). To explain the marked differences between the two sets of curves, it is helpful to
decompose the average markup as in the section on estimating the welfare gains from lower inflation. We can use the decomposition (equation 17) at any date to write the average markup as,
1
(20)
1−ε
1−η
µt =
(1−ε )
1 −η ( Pt −1 / Pt )
P*
t ,
ψt
also recognizing that the price level evolves according to equation 15 to describe the price adjustment gap as a function of the current and past price level.
Productivity shock dynamics under a fixed money supply rule. Under a fixed money
supply rule, we find the intuitive result that a permanent productivity shock will raise output
(Figure 6, panel A) and lower the current price level from its trend when prices are flexible. Since
capital and consumption grow slowly toward the new steady state, a situation of sustained defla562
November/December 2013
Federal Reserve Bank of St. Louis REVIEW
Centennial Issue
Figure 6
Money Supply Targeting, Response to a Permanent Productivity Shock
A. Output
Percent Deviations
_____ η = 0
_______ η = 0.75
B. Investment
Percent Deviations
1.6
1.8
1.2
1.4
1.0
0.8
0.6
0.4
0.2
–0.2
0
0 10 20 30 40 50 60 70 80
Quarters
0 10 20 30 40 50 60 70 80
Quarters
C. Consumption
D. Labor Input
Percent Deviations
Percent Deviations
0.4
1.6
1.2
0
0.8
–0.4
0.4
–0.8
0
–1.2
0 10 20 30 40 50 60 70 80
Quarters
0 10 20 30 40 50 60 70 80
Quarters
E. Markup
F. Real Wage
Percent Deviations
Percent Deviations
1.4
1.6
1.0
1.2
0.6
0.8
0.2
0.4
–0.2
0 10 20 30 40 50 60 70 80
Quarters
0
0 10 20 30 40 50 60 70 80
Quarters
G. Real Interest Rate
H. Real Balances
Percent Deviations
Percent Deviations
90
1.6
75
1.2
60
45
0.8
30
0.4
15
0
0 10 20 30 40 50 60 70 80
Quarters
Federal Reserve Bank of St. Louis REVIEW
0
0 10 20 30 40 50 60 70 80
Quarters
November/December 2013
563
King and Wolman
tion is shown in Figure 6: This is to be interpreted as the price level rising at less than the benchmark 5 percent rate.
If prices are sticky, there is also pressure for deflation. Accordingly, the first term in the
markup expression (equation 20) rises when the price level falls, increasing the markup: This is
the flip side of the inflation erosion effect discussed in the section on the price adjustment gap
and inflation. Since the productivity shock lowers marginal cost at date t and in all future dates,
there is a relatively small effect on the marginal markup component
Pt*
.
ψt
The average markup rises in response to the productivity shock. A rise in the markup
(Figure 6, panel E) implies an increase in the wedge between the marginal product of labor and
the real wage (Figure 6, panel F). Since the wedge will eventually return to its steady-state level,
there is a strong substitution effect that causes labor input (Figure 6, panel D) to fall in the impact
period.
The direction of the effect on labor contrasts with the case in which prices are flexible and
markups never deviate from e /(e –1). In this case, labor input rises as agents capitalize on the
temporarily high real interest rate. Thus under a money supply target, a sticky price economy
responds to shocks in a qualitatively different manner than a flexible price economy.
Productivity shock dynamics with a perfect inflation target. The results differ substantially
when there is a policy of perfectly targeting the inflation rate. Figure 7 displays comparable
impulse response functions in this case (the target inflation rate is 5 percent). A glance at Figure 7
reveals that, unlike the money growth target case, there is no qualitative difference between the
responses under fixed and flexible prices. The average markup decomposition is again helpful
in understanding this result. Because inflation targeting prevents shocks from affecting the price
level, it eliminates the price adjustment gap channel—the first term in the decomposition—so
that there is no tendency for the markup to rise (Figure 7, panel E). With the markup essentially
unchanged, the real wage fully inherits the increase in productivity. Thus, a major component
of the substitution effect acting to decrease labor supply disappears and, as in the flexible price
model, hours rise in accord with the opposing substitution effect of a temporarily high real interest rate (Figure 7, panels F, D, and G). Thus, perfect inflation targeting effectively makes a stickyprice economy behave like a flexible price economy: The key is that inflation targeting introduces
a monetary accommodation that avoids the necessity for the price level to fall in response to
permanent productivity shocks.15
Money Demand Shocks
Figure 8 displays the results of a permanent shock to the demand for money under fixed
money supply and price level paths, with the latter being equivalent to the outcome under flexible
prices just as it was in response to a technology shock. Our money demand shock corresponds
to a change in the cash balance efficiency condition such that there is a 1 percent higher demand
for real balances at given levels of consumption, the real wage rate and the nominal interest rate.
An important difference is evident between the two sets of results shown in Figure 8: An increase
564
November/December 2013
Federal Reserve Bank of St. Louis REVIEW
Centennial Issue
Figure 7
Inflation Targeting, Response to a Permanent Productivity Shock
A. Output
η = 0 (o)
B. Investment
Percent Deviations
η = 0.75 (+)
Percent Deviations
1.8
1.6
1.4
1.2
1.0
0.8
0.6
0.4
0.2
–0.2
0
0 10 20 30 40 50 60 70 80
Quarters
0 10 20 30 40 50 60 70 80
Quarters
C. Consumption
D. Labor Input
Percent Deviations
Percent Deviations
1.6
0.6
1.2
0.4
0.8
0.2
0.4
0
0 10 20 30 40 50 60 70 80
Quarters
0
0 10 20 30 40 50 60 70 80
Quarters
E. Markup
F. Real Wage
Percent Deviations
Percent Deviations
1.4
1.6
1.0
1.2
0.6
0.8
0.2
0
–0.2
0.4
0
0 10 20 30 40 50 60 70 80
Quarters
0 10 20 30 40 50 60 70 80
Quarters
G. Real Interest Rate
H. Real Balances
Percent Deviations
Percent Deviations
7
1.6
6
1.2
5
4
0.8
3
2
0.4
1
0
0
0 10 20 30 40 50 60 70 80
Quarters
Federal Reserve Bank of St. Louis REVIEW
0 10 20 30 40 50 60 70 80
Quarters
November/December 2013
565
King and Wolman
Figure 8
Response to a Permanent Money Demand Shock
A. Output
Percent Deviations
Inflation Target (o)
Money Supply Target (+)
0.2
B. Investment
Percent Deviations
0.4
0
–0.2
–0.4
–0.8
–0.6
–1.2
–1.0
0 10 20 30 40 50 60 70 80
Quarters
–1.6
0 10 20 30 40 50 60 70 80
Quarters
C. Consumption
D. Labor Input
Percent Deviations
Percent Deviations
0.1
0.4
0
–0.1
–0.4
–0.3
–0.8
–0.5
–0.7
–1.2
0 10 20 30 40 50 60 70 80
Quarters
–1.6
0 10 20 30 40 50 60 70 80
Quarters
E. Markup
F. Real Wage
Percent Deviations
Percent Deviations
1.8
0
1.4
–0.4
1.0
0.6
–0.8
0.2
–0.2
–1.2
0 10 20 30 40 50 60 70 80
Quarters
0 10 20 30 40 50 60 70 80
Quarters
G. Real Interest Rate
H. Real Balances
Percent Deviations
Percent Deviations
80
1.2
1.0
60
0.8
40
0.6
0.4
20
0.2
0
0 10 20 30 40 50 60 70 80
Quarters
566
November/December 2013
0
0 10 20 30 40 50 60 70 80
Quarters
Federal Reserve Bank of St. Louis REVIEW
Centennial Issue
in money demand produces a decline in output if there is a fixed path of money, whereas it has
no effect on output if policy is geared toward a stabilizing the price level.
IMPLEMENTATION ISSUES
We next discuss two sets of issues that would be a necessary part of implementing a policy
rule like that discussed above. First, we ask whether it is possible to use the nominal interest rate
as an instrument to implement a policy of controlling the price level in our model economy.
Second, we investigate the consequences of immediately transiting to a lower inflation rate.
Implementation with an Interest Rate Instrument
Many central banks employ a short-term interest rate as the instrument by which monetary
policy is implemented. To consider how our economy might respond to such an operating policy,
we posit a monetary policy rule of the form:
Rt = f ⋅ log ( Pt ) − log ( Pt ) , log ( Pt ) = log ( Pt −t ) + π .
The first of these specifications indicates that the monetary authority raises the short-term
nominal interest rate in response to increases in the general price level (Pt) relative to its trend
path (Pt), since we assume that the parameter f is positive. The second of these specifications is
our earlier requirement that the price level grow at a fixed target rate of inflation.16 In Figure 9,
we reconsider the response of the macroeconomy to an increase in productivity under this rule,
distinguishing between a strong and weak pattern of response.17
If the central bank follows a rule that requires it to respond strongly to deviations of the
price level from its target path, then it actually must respond very little, and the economy’s behavior closely resembles that under a perfect inflation target (these outcomes are the “o” path in
Figure 9). To understand this rule, it is important to recall a very small (maximum seven basis
points) response of the real interest rate under perfect price level targeting. Accordingly, by keeping the nominal rate essentially constant, the central bank can accommodate the productivity
shock and keep the price level close to its target path. In this case, the post–Lucas-critique structure of the model is important. The interest rate policy keeps the price level close to the target
because agents understand that deviations from the target would trigger large interest rate variations. This credible threat implies that such interest rate variations need never occur.
However, if the central bank responds only weakly to departures from the target path, then
an overshooting of components of real activity may occur in response to a productivity shock.
Essentially, in this setting, the central bank allows a gap between the actual and target price level
to emerge as a result of the productivity shock—given that the real interest rate would rise under
perfect inflation targeting, the policy rule makes the price level (not shown) rise initially in
response to the shock, lowering the markup and raising real quantities. Later the price level falls
back to the target path, but this is of little consequence for real activity since it is largely forecasted
by private agents.
Federal Reserve Bank of St. Louis REVIEW
November/December 2013
567
King and Wolman
Figure 9
Interest Rate Rule, Feedback from Price Level, Response to a Permanent Productivity Shock
A. Output
Percent Deviations
Strong Feedback (o)
Weak Feedback (+)
B. Investment
Percent Deviations
1.6
1.6
1.2
1.2
0.8
0.8
0.4
0.4
0
0
0 10 20 30 40 50 60 70 80
Quarters
0 10 20 30 40 50 60 70 80
Quarters
C. Consumption
D. Labor Input
Percent Deviations
Percent Deviations
1.6
0.28
0.24
1.2
0.20
0.16
0.8
0.12
0.08
0.4
0.04
0
0
0 10 20 30 40 50 60 70 80
Quarters
E. Markup
Percent Deviations
0 10 20 30 40 50 60 70 80
Quarters
F. Real Wage
Percent Deviations
1.6
0
–0.05
1.2
–0.10
0.8
–0.15
–0.20
0.4
–0.25
–0.30
0
0 10 20 30 40 50 60 70 80
Quarters
G. Real Interest Rate
H. Real Balances
Percent Deviations
10
Percent Deviations
1.6
5
1.2
0
0.8
–5
0.4
–10
0
0 10 20 30 40 50 60 70 80
Quarters
568
0 10 20 30 40 50 60 70 80
Quarters
November/December 2013
0 10 20 30 40 50 60 70 80
Quarters
Federal Reserve Bank of St. Louis REVIEW
Centennial Issue
Figure 10
Permanent Disinflation
A. Output
B. Money Stock
1.10
1.30
Inflation Rule
Inflation Rule
1.05
1.20
Old Path
Old Path
1.00
Money Supply Rule
1.10
0.95
Money Supply Rule
1.00
0.90
0.90
0.85
0
2
4
6
8
10
12
14
Quarters
0
2
4
6
8
10
12
14
Quarters
C. Price Level
1.15
Old Path
1.05
Inflation Rule
0.95
Money Supply Rule
0.85
0
2
4
6
8
10
12
14
Quarters
Thus, when policy is implemented by means of an interest rate instrument, the economy’s
response to shocks is highly sensitive to the specific form of the policy rule. Since rules involving
interest rates are inherently dynamic, understanding the implications of different policy settings
requires an understanding of the patterns of expectations generated by the rules in response to
a shock.
Timing of Implementation
If a central bank seeks to lower the inflation rate in the long run through an inflation targeting
rule, are there important costs of immediate implementation? In other words, should a gradual
approach to disinflation be preferred to an immediate one within our model economy?
Advocates of gradualism sometimes argue that a recession will result from abrupt disinflation.
Figure 10 shows the results of an experiment of lowering the annual rate of inflation from
5 percent to 3 percent under two alternative schemes. Under an inflation rule, there is no transitional output loss from disinflation—there is simply a small gain in real activity as labor flows
out of transactions activity and into the production of final goods. This outcome results from
Federal Reserve Bank of St. Louis REVIEW
November/December 2013
569
King and Wolman
the structure of price dynamics in the Calvo model, as previously discussed by Buiter and Miller
(1985) and Ball (1994). Inflation can readily jump from one of the steady states (considered
above) to another—there are no important inertial forces governing the inflation rate, as opposed
to the price level, within our model economy.
However, as indicated by the paths marked money supply rule, there are important consequences of a change in the money growth rate—as distinguished from a change in the inflation
rate—within the model. Since a lower long-run inflation rate will stimulate the demand for
money, the path of the price level must fall if there is a decline in the long-run rate of monetary
growth. The process of transition from a high price level path to a lower one can be associated
with substantial declines in economic activity, as Figure 10 makes clear.
SUMMARY AND CONCLUSIONS
We have explored the costs and benefits of inflation targeting in a modern macroeconomic
model of the link between nominal and real variables. From the St. Louis model of 1972, we
took an emphasis on monetarist specification of money demand, as well as of the importance of
expectations in price setting. From recent developments in macroeconomics, we took the money
demand function as arising from a specific transactions technology, rational expectations, and
explicit dynamic modeling of consumption, labor supply, investment, and price setting. More
specifically, we followed work by Calvo (1983), Rotemberg (1987), and Yun (1996) in modeling
an economy that combines short-run price stickiness with rational decisions of firms. We used
our setup to evaluate the potential costs and benefits of a policy of targeting the inflation rate.
Our conclusions are in line with those of earlier monetarists—Irving Fisher, Milton Friedman,
and the builders of the St. Louis model. We found that the target rate of inflation should be set
at a low level. At current U.S. levels of inflation, the benefits from low inflation (that is, the economy reduces its time spent making transactions) are first order and the frictions associated with
imperfect competition and gradual price adjustment are second order. We also found this perfect
inflation targeting policy produces responses to productivity and money demand shocks that
are in line with those which would arise in a flexible-price economy. Finally, we briefly explored
two issues associated with the implementation of an inflation targeting policy, showing that it
can be implemented with an interest rate instrument and that there can be an immediate disinflation without adverse consequences for real economic activity.
This study of an inflation-targeting policy leaves open many interesting questions. First, our
analysis of price dynamics following Calvo was relatively rudimentary in terms of the stochastic
structure of price adjustment. A more complete analysis would permit a richer time pattern of
anticipated adjustment and also permit that time pattern to respond to the state of the economy,
specifically to the average rate of inflation. Second, our analysis leaves open the important question
of how a regime of imperfectly credible inflation targets would operate. Third, it would be useful
to pose the counterfactual question, What would have been the welfare gains if the United States
had been on an inflation-targeting regime during the postwar period? These topics are the subject of our continuing research into inflation targets within a St. Louis model of the 21st century. ■
570
November/December 2013
Federal Reserve Bank of St. Louis REVIEW
Centennial Issue
NOTES
1
Andersen and Carlson (1972) discuss the central role of expectations in the St. Louis model. We further discuss their
modeling of expectations below.
2
Our timing convention for money demand embodies a view of the average cash balance holdings as a durable good
(as in Friedman, 1969) and is best exposited as follows. Suppose that the evolution of bonds is
1
Bt +1 + M t + Pt ct = Yt + Bt + Mt −1 ,
1 + Rt
where Yt is some measure of nominal income and Bt is the quantity of bonds maturing at t. Accordingly, the date t
cost of holding a unit of money from t to t + 1(Mt ) is the discounted value of the interest forgone,
Rt
,
1+ Rt
as in the text.
3
In the interest of making the model setup as simple as possible notationally, we are being a little cavalier about the
role of uncertainty. For certain cash flows, our discount factor is linked to one period interest rates by
−1
∆t , j = (1 + Rt ) …(1 + Rt + j−1 ) ,
where Rt is the nominal interest rate from t to t –1.
4
The introduction of investment adjustment costs is not necessary to any of the main conclusions that follow from in
our analysis below. However, as aconsequence of the evidence summarized in Chirinko (1993), there is a good reason
for incorporating this structural aspect into a modern macroeconomic model.
5
Nevertheless, the Calvo setup is a natural starting point for our analysis: In Dotsey, King, and Wolman (1996), we argue
that a somewhat more general time-dependent specification is formally a first-order approximation to a richer statedependent price-adjustment model.
6
This specification requires that we view the consumption and investment goods as the same constant elasticity of
substitution “aggregator” of differentiated products. Blanchard and Kiyotaki (1987) derive such individual product
demand functions for a model with just a consumption good.
7
The money stock is M1. The interst rate is a quarterly yield on commercial paper. We form m/c as the ratio of nominal
money to an annual nominal consumption expenditure series (including durables). We then divide by population
and express the figure in terms of quarterly time units by multiplying by 4. Similarly, we divide nominal quarterly per
capita consumption by a nominal wage rate, measured as average hourly earnings of production workers in manufacturing, in current dollars. The average value of the resulting c/w series indicates that a representative worker requres
249 hours of work per quarter to purchase consumption or about 20 hours per week. In terms of interpreting Figure 1,
however, the reader should know that we have rescaled c/w by dividing by average quarterly hours worked. Additional details on the data (and the data themselves) are provided in a replication diskette that you can request from
the authors.
8
Several recent papers make this point in differing settings. Benabou (1992) suggests that higher inflation may raise
the elasticity of demand in a search model, thus lowering the markup. In a model that shares the core neoclassical
structure of this article, but uses a differing pattern of price dynamics, Goodfriend (1995) also derives a link between
the markup and inflation.
9
Michael Woodford and Preston McAfee each forcefully pointed out this conclusion to us during presentations of this
paper.
10 This follows Baxter’s (1995) analysis of tax distortions in a variable labor supply setting.
11 For the parameter values we use, the markup is decreasing with inflation in a neighborhood of the Friedman rule.
This leads to the approximate optimality result discussed in the introduction to this section.
12 The h = 0.8 value is an upper bound for our analysis, given our demand parameter (m or e). With higher values of h,
there is a sufficiently large cost of getting stuck with a fixed price that it is optimal not to open a firm. This example
indicates an unfortunate tension between matching short-run price dynamics and longer run inflation responses in
the Calvo model, one reason for the generalizations considered in Dotsey, King, and Wolman (1996).
Federal Reserve Bank of St. Louis REVIEW
November/December 2013
571
King and Wolman
13 That is, the slope of the solid line is infinitely negative at p f in Lucas’s analysis rather than slightly positive as in our
analysis.
14 The impulse response functions in Figures 6 to 10 were generated by linearizing the model around its deterministic
steady-state growth path, using the singular linear system methods detailed in King and Watson (1995a and b).
15 A formal welfare comparison supports the conclusion that sticky price and flexible price economies are not very dif-
ferent under perfect inflation targeting. To produce this measure in an earlier draft of the article, we determined the
welfare effect of a shock using the dynamic equivalent of the measure described in the section on optimal inflation
policy in the long run and illustrated in the right panel of Figure 2. Linear approximation methods were used to compute these welfare changes that are related to the measure of the Hicksian wealth effects of shocks produced in King
(1993).
16 McCallum (1981) makes it clear that such interest rate policies are a feasible mode of central bank behavior so long
as policy is conducted so as to produce a nominal anchor for the price level. Fang, Kerr, and King (1995) show that an
interest rate policy will result in unique outcomes so long as f > 0.
17 We chose these values [f = 500 (strong policy) and f = 0.1 (weak policy)] to produce clear graphics that illustrate the
nature of the policy rule.
REFERENCES
Abel, Andrew B., and Ben S. Bernanke. Macroeconomics. Addison-Wesley, 1992.
Andersen, Leonall C., and Keith M. Carlson. “An Econometric Analysis of the Relation of Monetary Variables to the
Behavior of Prices and Unemployment,” in The Econometrics of Price Determination, Otto Eckstein, ed. Board of
Governors of the Federal Reserve System, 1972, pp. 166–83.
Andersen, Leonall C. and Jerry Jordan. “Monetary and Fiscal Actions: A Test of their Relative Importance in Economic
Stabilization,” Federal Reserve Bank of St. Louis Review (October 1968), pp. 29–44.
Bailey, Martin J. National Income and the Price Level: A Study in Macroeconomic Theory, 2nd ed. McGraw Hill, 1971.
Ball, Laurence. “Credible Disinflation with Staggered Price Setting,” The American Economic Review (Vol. 84, 1994),
pp. 282–89.
Barro, Robert J. Macroeconomics, 3rd ed. Wiley, 1990.
Benabou, Roland. “Inflation and Markups: Theories and Evidence from the Retail Trade Sector,” European Economic
Review (Vol. 36, 1992), pp. 566–74.
Blanchard, O. J., and N. Kiyotaki. “Monopolistic Competition and the Effects of Aggregate Demand,” The American
Economic Review (September 1987), pp. 647–66.
Bodkin, Ronald G. “Wage and Price Formation in Selected Canadian Econometric Models,” in The Econometrics of Price
Determination, Otto Eckstein, ed. Board of Governors of the Federal Reserve System, 1972, pp. 369–85.
Buiter, Willem H., and Marcus H. Miller. “Costs and Benefits of an AntiInflationary Policy: Questions and Issues,” in
Inflation and Unemployment: Theory, Experience, and Policymaking, Victor E. Argy and John W. Neville, eds. London:
Allen and Unwin, 1985.
Calvo, G. A. “Staggered Prices in a Utility-Maximizing Framework,” Journal of Monetary Economics (September 1983),
pp. 383–98.
Chirinko, Robert S. “Business Fixed Investment Spending: A Critical Survey of Modelling Strategies, Empirical Results,
and Policy Implications,” Journal of Economic Literature (Vol. 31, 1993), pp. 1,875–911.
Cooley, Thomas F., and Gary D. Hansen. “Tax Distortions in a Neoclassical Monetary Economy,” Journal of Economic
Theory (December 1992), pp. 290–316.
de Menil, George, and Jared J. Enzler. “Prices and Wages in the FRMIT-Penn Econometric Model,” in The Econometrics of
Price Determination, Otto Eckstein, ed. Board of Governors of the Federal Reserve System, 1972, pp. 277–308.
Dotsey, Michael; Robert G. King; and Alexander L. Wolman. “State Dependent Pricing and the Dynamics of Business
Cycles.” Manuscript, University of Virginia and Federal Reserve Bank of Richmond, 1996.
572
November/December 2013
Federal Reserve Bank of St. Louis REVIEW
Centennial Issue
Eckstein, Otto, ed. The Econometrics of Price Determination, Board of Governors of the Federal Reserve System, 1972.
Eckstein, Otto and Gary Fromm. “The Price Equation,” The American Economic Review (Vol. 58, 1968), pp. 1,159–83.
Eckstein, Otto and David Wyss. “Industry Price Equations,” in The Econometrics of Price Determination, Otto Eckstein, ed.
Board of Governors of the Federal Reserve System, 1972, pp. 133–65.
Fang, Justin; William Kerr; and Robert G. King. “Limits on Interest Rate Rules in the IS Model.” Manuscript, University of
Virginia, 1995.
Friedman, Milton. The Optimum Quantity of Money, and Other Essays. Aldine Publishing Company, 1969.
Friedman, Milton and Anna J. Schwartz. A Monetary History of the United States 1867–1960. Princeton University Press,
1963a.
Friedman, Milton and Anna J. Schwartz. “Money and Business Cycles,” Review of Economics and Statistics (February
1963b), pp. 32–78.
Goodfriend, Marvin S. “A Framework for the Analysis of Moderate Inflations.” Manuscript, Federal Reserve Bank of
Richmond, 1995.
Gordon, Robert J. “Discussion of Papers in Session II,” in The Econometrics of Price Determination, Otto Eckstein, ed.
Board of Governors of the Federal Reserve System, 1972, pp. 202–12.
Hayashi, Fumio J. “Tobin’s Marginal q and Average q: A Neoclassical Interpretation,” Econometrica (January 1982),
pp. 213–24.
Ibbotson, Roger, and Rex Sinquefeld. Stocks, Bonds, Bills and Inflation: The Past and the Future. The Financial Analysts’
Research Foundation, 1982.
King, Robert G. “Value and Capital in the Equilibrium Business Cycle Program,” in Value and Capital: Fifty Years Later,
L. McKenzie and S. Zamagni, eds. London: MacMillan (1993), pp. 279–309.
King, Robert G. and Mark W. Watson. “The Solution of Singular Linear Difference Models Under Rational Expectations.”
Manuscript, University of Virginia, 1995a.
King, Robert G. and Mark W. Watson. “System Reduction and Solution Algorithms for Singular Linear Difference
Systems Under Rational Expectations.” Manuscript, University of Virginia, 1995b.
Lucas, Robert E., Jr. “Econometric Policy Evaluation: A Critique,” Carnegie-Rochester Conference Series on Public Policy
(Vol. 1, no. 2 1976), pp. 19–46.
Lucas, Robert E., Jr. “On the Welfare Cost of Inflation.” Manuscript, for the Hitotsubashi International Symposium of
Financial Markets and the Changing World, 1993.
Lucas, Robert E., Jr. “Supply Side Economics: An Analytical Review,” Oxford Economic Papers (April 1990), pp. 293–316.
McCallum, Bennett T. “Price Level Determinacy with an Interest Rate Rule and Rational Expectations,” Journal of
Monetary Economics (Vol. 8, 1981), pp. 319–29.
McCallum, Bennett T. and Marvin S. Goodfriend. “Theoretical Studies of the Demand for Money,” in The New Palgrave:
A Dictionary of Economics; John Eatwell, Murray Milgate, and Peter Newman, eds. Stockton Press, 1987, pp. 775–81.
Okun, Arthur M. “Potential GNP: Its Measurement and Significance,” Proceedings of the Business and Economic
Statistics Section of the American Statistical Association, 1962, pp. 98–104.
Rotemberg, Julio J. “The New Keynesian Microfoundations,” NBER Macroeconomics Annual. MIT Press, 1987, pp. 69–104.
Tobin, James. “The Wage-Price Mechanism: Overview of the Conference,” in The Econometrics of Price Determination,
Otto Eckstein, ed. Board of Governors of the Federal Reserve System, 1972, pp. 5–15.
Tobin, James. “Inflation and Unemployment,” The American Economic Review (March 1972b), pp. 1–18.
Wolman, Alexander L. “Three Essays on Monetary Economics.” Unpublished dissertation, University of Virginia, 1996.
Yun, Tack. “Nominal Price Rigidity, Money Supply Endogeneity, and Business Cycles,” Journal of Monetary Economics
(Vol. 37,1996), pp. 345–370.
Federal Reserve Bank of St. Louis REVIEW
November/December 2013
573
574
November/December 2013
Federal Reserve Bank of St. Louis REVIEW
Centennial Issue
Announcements and the Role of Policy Guidance
Carl E. Walsh
By providing guidance about future economic developments, central banks can affect private sector
expectations and decisions. This can improve welfare by reducing private sector forecast errors, but it
can also magnify the impact of noise in central bank forecasts. I employ a model of heterogeneous information to compare outcomes under opaque and transparent monetary policies. While better central bank
information is always welfare improving, more central bank information may not be. (JEL E52, E58)
This article first appeared in the July/August 2008 issue of Review.
Federal Reserve Bank of St. Louis Review, November/December 2013, 95(6), pp. 575-600.
tandard models used for monetary policy analysis typically assume that households and
firms and the central bank share a common information set and economic model, yet
actual policy decisions are taken in an environment in which heterogeneous information
is the norm and many alternative models coexist. The resulting heterogeneity in views can play
an important role in affecting both policy choices and the monetary transmission process.
Transparency in the conduct of policy can help to reduce heterogeneous information. Inflationtargeting central banks, for example, make significant attempts to reduce uncertainty about
policy objectives, such as through the release of detailed inflation and output projections, to
ensure the public shares central bank information about future economy developments. By
being transparent about its objectives and its outlook for the economy, central banks help provide the public with guidance about the future.
But providing guidance carries risks. As Poole (2005, p. 6) has expressed it, “[F]or me the
issue is whether under normal and routine circumstances forward guidance will convey information or whether it will create additional uncertainty.”
Because any forecast released by the central bank is subject to error, being more transparent
may simply lead the private sector to react to what was, in retrospect, noise in the forecast. The
possibility that the private sector may overreact to central bank announcements does capture a
S
At the time this article was written, Carl E. Walsh was a professor of economics at the University of California, Santa Cruz, and a visiting scholar at
the Federal Reserve Bank of San Francisco.
This article has been reformatted since its original publication in Review: Walsh, Carl E. “Announcements and the Role of Policy Guidance.” Federal
Reserve Bank of St. Louis Review, July/August 2008, 90(4), pp. 421-42; http://research.stlouisfed.org/publications/review/08/07/Walsh.pdf.
© 2013, The Federal Reserve Bank of St. Louis. The views expressed in this article are those of the author(s) and do not necessarily reflect the views
of the Federal Reserve System, the Board of Governors, or the regional Federal Reserve Banks. 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.
Federal Reserve Bank of St. Louis REVIEW
November/December 2013
575
Walsh
concern expressed by some policymakers. For example, in discussing the release of Federal Open
Market Committee (FOMC) minutes, Janet Yellen expressed the view that “Financial markets
could misinterpret and overreact to the minutes” (Yellen, 2005, p. 1).
In this paper, I explore the role of economic transparency—specifically, transparency about
the central bank’s assessment of future economic conditions—in altering the effectiveness of
monetary policy. I do so in a framework in which central bank projections may convey useful
information but may also introduce inefficient fluctuations into the economy.
A focus on economic transparency seems appropriate for understanding the issues facing
many central banks. The recent concerns about the implications of the subprime mortgage market reflect, in part, private sector uncertainty about the Fed’s view of the economic outlook and
the way the outlook for inflation and real economic activity may be affected by financial market
conditions. Throughout 2007, for example, many financial market participants appeared to hold
more pessimistic views than the Federal Reserve about future economic developments1; and in
recent months, market participants have often expected significant interest rate cuts, while some
members of the FOMC have emphasized concerns about the outlook for inflation, suggesting
they saw less need for rate reductions. News reports speculating on possible interest rate cuts by
the Fed or the European Central Bank focused very little on uncertainty about central bank preferences but a great deal on the uncertainty about the outlook for the economy. These reports
reveal heterogeneity among private forecasters and uncertainty about the Fed’s (or the European
Central Bank’s) outlook for the economy. And public statements by central bankers were designed
to communicate their views on future economic developments. Jean-Claude Trichet’s statement
that the markets “have gone progressively back to normal” (Atkins, Mackenzie, and Davies, 2007,
p. 1) and Ben Bernanke’s (2007) comment that housing remains a “significant drag” on the economy, both exemplify how central bankers signal their assessment of economic conditions, and
this assessment is one factor that influences the (heterogeneous) outlooks among members of
the private sector.
The uncertainty in financial markets in recent months illustrates clearly the significant differences that can arise between the central bank and private market participants. This is a classic
example of heterogeneous information about the economy. Much of the debate has been focused
on the question of future interest rate cuts, but the underlying issues appear to be related to differing views among private forecasters and between private forecasters and the Fed over the likely
impact of financial market disturbances on the real economy and the likelihood of a future
recession.
The next section discusses the two goals of transparency Bill Poole (2005) has stressed—
accountability and policy effectiveness. The third section develops a model of asymmetric and
heterogeneous economic information that can be used to model the implications of transparency.
Two policy regimes are considered. In the first, the public observes the policy instrument of the
central bank but the central bank provides no further information to the public. In the second,
the central bank provides information on its outlook for future economic developments. The
welfare implications of these regimes are discussed in the fourth section. Within each regime,
better quality central bank information is always welfare improving (the pro-transparency aspect
of Morris and Shin, 2002, emphasized by Svensson, 2006). However, across regimes, more central
bank information has ambiguous effects.
576
November/December 2013
Federal Reserve Bank of St. Louis REVIEW
Centennial Issue
THE GOALS OF TRANSPARENCY
Transparency requires asymmetric information, but the nature of this asymmetry can take
many forms. In fact, Geraats (2002) has classified five types of transparency—political, procedural, economic, policy, and operational. Briefly, these correspond to central bank transparency
about objectives, the internal decisionmaking process, forecasts and models, policy actions, and
instrument setting and control errors. Each of these dimensions of transparency is important
and has been studied extensively (see Geraats, 2002, for a survey).
In recent years, central banks have become more transparent along all these dimensions,
and levels of transparency that would have been viewed as exceptional 20 years ago are today
accepted as best practice among modern central banks.2 The trend toward independent central
banks with explicit mandates assigned to them and the widespread adoption of inflation targeting
has contributed greatly to political transparency. The Bank of England is among the most procedurally transparent central banks, publishing minutes and individual votes of its Monetary
Policy Committee discussions. Central banks, such as the Federal Reserve, that were formerly
reluctant to communicate policy actions directly now do so clearly, timely, and directly. The most
transparent central banks, such as the Reserve Bank of New Zealand and the Bank of Norway,
publish their projections for the policy interest rate. The use of a short-term interest rate as the
policy instrument has greatly enhanced operational transparency. But although most central
banks today are transparent about their policy stance and operational procedures—something
hard to avoid when the policy instrument is a short-term market interest rate—there is much
greater variation in the extent to which central banks are transparent about their decisionmaking
process, their internal forecasts, and their policy objectives.
But what is the point of being transparent? As noted earlier, Poole (2006) has articulated two
goals of transparency: to meet the Fed’s “responsibility to be politically accountable” and “to make
monetary policy more effective.” The next two subsections discuss each of these goals.
Transparency and Accountability
The role transparency plays in supporting accountability can differ depending on whether
the ultimate objectives of monetary policy are observable or unobservable. Consider first the
case in which the objectives of monetary policy are, ex post, clearly measurable and observable.
For concreteness, assume inflation is the only objective of the central bank and there is agreement
on the appropriate measure of inflation that the central bank should control. In this environment,
it is in principle straightforward to ensure accountability. Observing the ex post rate of inflation
would seem to provide a simple means for judging the performance of the central bank. However,
even under the conditions specified (a single measurable objective), the ex post realization of
inflation is not a sufficient performance measure. The reason is that inflation is not directly controllable—even under an optimal policy (where the central bank is doing exactly what it should
be doing), the realized inflation rate can differ from the desired value. This difference may be
small, but as long as there is any random variation that is beyond the ability of the central bank
to eliminate, public accountability based solely on inflation outcomes will punish some good
central bankers and reward some lucky ones.
Federal Reserve Bank of St. Louis REVIEW
November/December 2013
577
Walsh
Transparency can help promote accountability by allowing the public to base its evaluation
of the central bank not just on observed inflation but on the information that was available to
the central bank when it had to make its policy decision. Having access to internal bank forecasts, for example, allows outsiders to evaluate the decisions made by the central bank. This can
mitigate some of the problems associated with evaluations based solely on realized inflation.
Having access to the information on which decisions were based helps remove the influence of
random uncontrollable events that affect inflation and therefore supports a better system of
accountability.3
In general, however, policy objectives are not directly observable, and they may even be
inherently unmeasurable. Certainly, recent theoretical models, which have emphasized the use
of the welfare of the representative agent as the appropriate objective of policy, have defined optimal policy in terms of unmeasurable objectives. It is not clear that we could reach agreement on
the correct way to measure welfare, as that depends on the specific model we believe characterizes the economy, even if we could agree on how to define welfare. It certainly is not observable.
Transparency can be especially critical when objectives are unobserved. Assessing, or holding accountable, an economic agent when objectives are unobservable is not a situation unique
to monetary policy and central banks. Education is perhaps the most prominent field in which
public policy must deal with this situation; the objectives are high-quality education and teaching but there exists wide disagreement over how to define and measure these qualities.
Because social welfare does depend on inflation and inflation can be observed, one might
use inflation as a type of performance measure, holding the central bank accountable for achieving a low and stable inflation rate. Inflation targeting can be thought of as defining a performance
measure for the central bank. The critical issue in choosing any performance measure, however,
is how powerful one wants to make the incentives. If accountability is based strictly on realized
inflation and the consequences of missing the target are large, then the central bank will naturally
focus on achieving the target, even if this means sacrificing other, more difficult to measure,
aspects of social welfare. The concern that inflation-targeting produces too much of a focus on
inflation control is at the heart of most criticisms of inflation targeting in the United States.
But this is where transparency becomes particularly important. Greater transparency can
lessen the need to rely on a single easily measured performance indicator. When there is greater
transparency, and the public is able to assess the same information the central bank has used to
set policy, it is no longer necessary to base central bank accountability on inflation outcomes
only (Walsh, 1999).
Transparency and the Effectiveness of Monetary Policy
Poole’s second goal of transparency, promoting policy effectiveness, requires that private
sector decisions be influenced, and influenced systematically, by the information central banks
provide. With the development of New Keynesian models and their emphasis on the importance
of forward-looking behavior, managing expectations to improve policy effectiveness has taken
on a new importance. Woodford (2005) has gone so far as to state that “not only do expectations
about policy matter, but, at least under current conditions, very little else matters.”4
578
November/December 2013
Federal Reserve Bank of St. Louis REVIEW
Centennial Issue
The intuition for Woodford’s statement is straightforward. Policymakers control directly
only a short-term interest rate. Yet rational agents are forward looking and so base their spending and pricing decisions on their assessment of future interest rates, not just current rates. The
recognition that expectations matter is not confined to academics; a recent article in the Financial
Times (Guha, 2007) states that “What really matters, both for the markets and the economy, is
not the current policy rate but the expected path of future rates.”
Transparency and its relationship to policy effectiveness played a key role in the large literature that focused on the average inflation rate bias that could arise under optimal discretionary
policy. By and large, this literature emphasized political and operational transparency, and it
employed models in which policy surprises were the source of the real effects of monetary policy.
Geraats (2002) provides an excellent survey of the literature.
In these models, the central bank preferences were generally treated as stochastic and
unknown. The policy instrument was also taken to be observed with error or subject to a control
error. For example, the central bank might control nonborrowed reserves, but this allowed only
imperfect control of the money supply.5 Observing money growth would not provide enough
information for the public to disentangle the effects of control errors from shifts in central bank
preferences. Thus, there was opaqueness about political objectives and operational implementation. Transparency was typically modeled as a reduction in the noise in the signal on the policy
instrument. The optimal degree of transparency ensured the public would learn quickly when
the central bank preferences shifted, but still left open the possibility that the bank could create
a surprise if one was needed to aid stability. Cukierman and Meltzer (1986) showed that the
central bank may prefer to adopt a less efficient operating procedure than is technically feasible
(i.e., not reduce the control error variance to its minimum possible level).6
As emphasized in recent discussions of transparency, however, New Keynesian models imply
that it is predictable monetary policies, not surprises, that are most effective in achieving policy
goals. In such an environment, transparency, rather than reducing the efficacy of policy can actually increase it. Central bank announcements about future policy actions, or about future economic developments, can affect private sector expectations of future interest rates, inflation, and
economic activity. With spending and pricing decisions dependent on these expectations, using
announcements to influence expectations gives the central bank an additional policy instrument.
As such, it serves to make policy more effective. The argument that transparency can increase
the effectiveness of monetary policy is certainly more consistent with the modern practice of
central banks, which has been uniformly to move in the direction of greater transparency.
But providing information to the public may have potential costs. These costs are associated
with the conditional nature of any forecast. Some economists have worried that the public will
not understand the distinction between a conditional and an unconditional forecast.7 Particularly
because reputation is important, deviating from a previously announced policy path may be
interpreted as a deviation from a commitment equilibrium rather than as an appropriate response
based on new information. If a central bank fails to raise interest rates after signaling that it
planned to, the private sector may believe the bank has become less concerned about inflation,
causing inflation expectations to rise. Financial market participants may underestimate the
conditionality of the announced rate path and so view deviations as introducing unwarranted
Federal Reserve Bank of St. Louis REVIEW
November/December 2013
579
Walsh
uncertainty into financial markets. These factors may make the central bank reluctant to adjust
rates, producing a lock-in effect that would reduce flexibility and limit policy effectiveness.
Even when the public understands the conditional nature of the guidance provided by the
central bank, announcements may introduce new sources of volatility. The influential paper by
Morris and Shin (2002) has highlighted one channel through which central bank announcements
may have a detrimental effect. Unlike standard models that assume all private agents share the
same information, Morris and Shin focus on the more realistic case in which private agents have
individual, heterogeneous sources of information and must attempt to forecast what others are
expecting.8 Morris and Shin have argued that there can be a cost to providing more-accurate
public information; agents may overreact to public information, making the economy more
sensitive to any forecast errors in the public information.
Subsequent research (e.g., Hellwig, 2004, and Svensson, 2006) has suggested that the MorrisShin result is not a general one and that better, more accurate, central bank information is welfare
improving. However, just as the earlier literature on transparency employed models at odds with
current policy frameworks (only surprises mattered, the money supply was the instrument), the
Morris-Shin analysis is conducted within a framework that fails to capture important aspects of
actual monetary policy. For example, the issue facing most central banks is not whether to provide more-accurate forecasts. Instead, the issue is whether or not to provide more information
by, for example, announcing forecasts. And even in the absence of explicit announcements or
guidance, central banks already provide information through the setting of the policy instrument.
The impact of a change in the policy instrument will depend, in part, on the information that it
conveys about the central bank’s view of the economy.
The work by Morris and Shin has been extended by Amato and Shin (2003), who cast the
Morris-Shin analysis in a more standard macro model. In their model, the central bank has perfect information about the underlying shocks. This ignores the uncertainty policymakers themselves face in assessing the state of the economy. Nor do Amato and Shin allow the private sector
to use observations on the policy instrument to draw inferences about central bank information.
They also assume one-period price setting and represent monetary policy by a price level–targeting
rule. In Hellwig (2004), prices are flexible and policy is given by an exogenous stochastic supply
of money; private and public information consists of signals on the nominal quantity of money.
The potential costs and benefits of releasing central bank forecasts have also been analyzed
by Geraats (2005). However, Geraats assumes agents do not observe the bank’s policy instrument
prior to forming expectations and employs a traditional Lucas supply function. Her focus is on
reputational equilibria in a two-period model with a stochastic inflation target. Thus, the model
and the issues addressed differ from the focus on the role of information in a Morris-Shin-like
environment.
Rudebusch and Williams (2006) and Gosselin, Lotz, and Wyplosz (forthcoming) focus specifically on the provision of future interest rate projections. Rudebusch and Williams explore the
role of interest rate projections in a model of political transparency—the asymmetry of information pertains to policy preferences and the central bank inflation target. Transparency is modeled
as reducing noise in central bank projections. In contrast to the model I develop in the next section, Rudebusch and William incorporate learning and find that the public’s ability to learn and
welfare increase when interest rate projections are provided.
580
November/December 2013
Federal Reserve Bank of St. Louis REVIEW
Centennial Issue
Gosselin, Lotz, and Wyplosz (forthcoming) adopt a quite different approach and focus on
what they characterize as creative opacity. In their model, the private sector learns from the
information released by the central bank, but the central bank also learns about private sector
information by observing long-term interest rates. By providing its projection for the short-term
interest rate, the central bank is able to recover private sector information from the long-term
rate. This aligns expectations but may require the central bank to distort its current interest rate
setting to achieve the desired long-term rate. If central bank information is poor, it may be better
to remain opaque. Although the role of central bank learning is a critical one, I ignore it in the
model in the next section in order to focus on the way inflation and output are affected by central
bank announcements.
Thus, several questions remain unresolved concerning the role of transparency in an environment in which agents have heterogeneous information and central bank actions and announcements are commonly available. Specifically, how does the information conveyed by the central
bank instrument affect the central bank’s incentives and alter the effectiveness of policy?9 What
is the effect of more information as opposed to better information? And are concerns about the
added uncertainty of greater transparency warranted? These questions are addressed in the
model in the next section.
WELFARE EFFECTS OF OPAQUENESS AND TRANSPARENCY
To investigate the role of economic transparency, I employ a simple model motivated by
New Keynesian models based on Calvo-type pricing adjustment by monopolistic firms and by
Morris and Shin’s (2002) demonstration of the role heterogenous information can play.10 Like
Gosselin, Lotz, and Wyplosz (forthcoming), I assume the central bank’s preferences are known.
Unlike their model, however, I incorporate the common-knowledge effect central to the Morris
and Shin model. However, I focus on how the private sector learns from information provided
by the central bank and ignore the reverse inference, where the central bank learns from private
sector information, which is key in the Gosselin, Lotz, and Wyplosz model.
The basic model is similar to the one employed in Walsh (2007a,b). In these earlier papers,
however, only demand and cost shocks were present, so it was necessary to make just a single
projection (of inflation or the output gap) to fully reveal the central bank information (because
the public also observed the policy instrument). The primary focus was also on partial transparency in the sense of Cornand and Heinmann (2004). The chief contributions of the present
paper are to enrich the information structure, to account fully for the welfare costs of relative price
dispersion created by heterogeneous information, and to assess transparency in terms of both
quantity (the role of providing more information) and quality (the effect of better information).
Firms receive private signals on the fundamental shocks affecting the economy. Each period,
a fraction of firms adjust their prices. In doing so, they are concerned with their relative price
and so must attempt to forecast what other price-adjusting firms are doing. But this requires the
individual firm to predict what other firms are predicting about the shocks hitting the economy.
Hence, higher-order expectations will matter, as in Morris and Shin (2002).
Federal Reserve Bank of St. Louis REVIEW
November/December 2013
581
Walsh
The central bank, like individual firms, is assumed to possess potentially noisy information
on the economic outlook. I consider two policy regimes. In the first, the opaque regime, denoted
by superscript o, the central bank makes no announcements. However, even in this regime, the
central bank reveals something about its outlook for the economy when it sets its policy instrument. In the absence of other information, the private sector forms expectations by combining
the observation on the instrument with their own private information. A rise in the policy interest
rate, for example, will be interpreted partially as a central bank attempt to offset a projected positive demand shock and partially as an attempt to contract real output to offset a positive cost
shock. When deciding on its policy, the central bank needs to take into account how the public
will interpret its actions because the instrument conveys information.
The second regime, denoted by superscript f, corresponds to full transparency. In this regime,
the central bank releases its projections on future economic developments. Because it is on this
information that the central bank bases its policy decision, the actual setting of the instrument
conveys no additional information. The benefits of this regime are that private sector forecasts
are improved and, because there is more common information across firms, relative price dispersion is reduced. The potential cost is that private expectations react to what may turn out
ex post to be central bank forecast errors.
While I assume the central bank operates in a discretionary manner in setting its policy
instrument, I also assume it can commit to a policy regime (opaque or transparent).
The Basic Model
The underlying model of price adjustment is based on Calvo, combined with the timing
assumptions of Christiano, Eichenbaum, and Evans (2005) and the addition of firm-specific
information. The Christiano, Eichenbaum, and Evans timing implies that firms who adjust their
price for period t do so based on t–1 information. Expressed alternatively, firms in period t make
decisions about their prices for period t+1. Because information differs across firms, price-setting
firms will not all set the same price as in the standard common-information framework that is
employed in most models. In addition, because firms care about their relative price, they must
forecast the aggregate t+1 price level when they set their individual price for that period. This
also differs from standard specifications in which firms are assumed to know the aggregate
equilibrium price level when they set their price level.
Three types of shocks are considered: (i) costs shocks that are assumed to represent inefficient volatility in real marginal costs; (ii) aggregate demand shocks; and (iii) shocks to the gap
between the economy’s flexible-price equilibrium level of output and its efficient level of output.
The last one will be referred to as a welfare-gap shock. The model differs from standard New
Keynesian models in that the same information is not commonly available to all firms and firms
must set prices before observing the current realizations of shocks.
The basic timing is as follows:
(i) At the end of period t, the central bank forms projections about t+1 economic conditions
and sets its policy instrument, qt .
(ii)Firms observe pt , xt , and qt as well as individual specific signals about t+1 shocks. Firms
may also observe announcements made by the central bank.
582
November/December 2013
Federal Reserve Bank of St. Louis REVIEW
Centennial Issue
(iii)Those firms that can adjust their price set prices for t+1.
(iv) Period t+1 shocks occur and pt+1 and xt+1 are realized.
A randomly chosen fraction 1– w of firms optimally set their price for period t+1. If b is the
discount factor (see Walsh, 2007b), one can show that
(1)
ωβ j
π *j ,t +1 = (1 − ω ) Etj π t*+1 + (1 − ωβ ) κ Etj xt+1 + (1 − ωβ ) Etj ets+1 +
E π ,
1 − ω t t+2
where p*j,t+1 is the log price firm j sets for period t+1 relative to the period t average log price
*
level (i.e., p*j,t+1 – pt ); E tj p–t+1
is firm j’s expectation about the average p*i,t+1 being set by other
s
is the aggregate,
adjusting firms; E tj xt+1 is firm j’s expectation about the output gap in t+1; et+1
j
common cost shock; and E t pt+2 is firm j’s expectation about future inflation. For simplicity, I
assume (1) is linearized around a zero-inflation steady state.
To keep the model simple, I represent the demand side of the model in a very stylized,
reduced-form manner. Monetary policy is represented by the central bank’s choice of qt and by
any announcements the central bank might make. I assume qt is observed at the start of the
period so that any firm that sets its price in period t can condition its choice on the central bank’s
policy action. The output gap is then equal to
(2)
xt +1 = θt + etv+1 ,
where evt+1 is a demand shock. Although I will call qt the central bank instrument, it essentially
represents the central bank’s intended output gap.
Information. As noted, there are three fundamental disturbances in the model: ets represents
cost factors that, for a given output gap and expectations of future inflation, generate inefficient
inflation fluctuations; etv the aggregate demand disturbance; and etu a shock to the gap between
the flexible-price output gap and the efficient output gap. I assume each is serially and mutually
uncorrelated.
Firms must set their prices and the central bank must set its policy instrument before learni
ing the actual realizations of the aggregate shocks. Firm j’s idiosyncratic information, e j,t+1
for
i = s, v, u, is related to the aggregate shock according to
e ij ,t +1 = eti+1 + φ ij ,t +1 , i = s ,v ,u.
i
terms are identically and independently distributed across firms and time. These sigThe f j,t+1
i
nals are private in that they are unobserved by other agents. For convenience, each f j,t+1
will be
s
referred to as a noise term, even though f j,t+1 is actually the idiosyncratic component of the firm’s
cost shock. All stochastic variables are assumed to be normally distributed. Define the signal-tonoise ratio, g ji = s 2i /(s 2i + s 2j,i ), where s 2i is the variance of ei and s 2j,i is the variance of f ji. Let
Wj,t+1 denote the vector of private signals received by firm j, and let Wt+1 = 兰Wj,t+1 be the information aggregated across firms.
The central bank combines its information, models, and judgment to obtain forecasts of
future economic disturbances. It will be convenient to represent this information, in parallel
with the treatment of firm information, as signals on the three aggregate disturbances:
Federal Reserve Bank of St. Louis REVIEW
November/December 2013
583
Walsh
ecbi ,t = eti+1 + φcbi ,t , i = s ,v ,u.
i
The noise terms fcb
are assumed to be independently distributed and to be independent of f ji
i
i
for all i, j, and t. Define g cb
= s 2i /(s 2i + s 2i,cb ), where s 2i,cb is the variance of fcb
. Let Wcb,t+1 denote
s v u
cb
the innovation to the central bank information set. Let Z¢t = [et et et ]. Then Et Zt+1 = Gcb Wcb,t+1,
where E cb denotes expectations conditional on central bank information and
γs
cb 0 0
Γ cb = 0 γ cbv 0
0 0 γ cbu
.
The central bank’s objective is to minimize, under discretion, a standard quadratic loss
function that depends on inflation variability and output-gap variability. Specifically, loss is
given by
∞
(3)
Lcbt = Etcb
∑β π
i
2
t +i
+ λx ( xt +i − etu+i ) ,
i =0
where etu
is equal to stochastic variation in the gap between the flexible-price output gap (x) and
the welfare-maximizing output gap.
With staggered price adjustment, New Keynesian models imply that the welfare costs of
inflation variability arise from the dispersion of relative prices it generates (Rotemberg and
Woodford, 1997, Woodford, 2003a). Relative price dispersion can arise from inflation (because
of staggered price adjustment) and because of heterogeneous information across firms. It can be
shown (see the appendix) that the variance of relative prices across firms depends on p t2 and on
the noise in the signals received by individual firms. Thus, social loss is given by
∞
(4)
Lst = Et
∑β π
i
2
t +i
+ λ I z t2+i + λ x ( xt +i − etu+i ) ,
i =0
where zt2 is relative price dispersion arising from heterogenous information across individual
firms, with the appropriate weight on this source of loss relative to p t2 given by
(1 − ω ) .
2
λI =
ω
The loss associated with heterogeneous information can be reduced if the central bank provides more information. However, this loss is not affected by the period-by-period policy choice
the central bank makes in setting its instrument (conditional on the policy regime that defines
the type of announcements the central bank makes). Thus, under discretion, the central bank
takes as given the term zt2 in (4), which is due to heterogeneous information, and minimizes (3).
We can now evaluate equilibrium under each policy regime.
584
November/December 2013
Federal Reserve Bank of St. Louis REVIEW
Centennial Issue
Equilibrium Under the Opaque Regime
In regime o, firms observe their own private signals and the central bank instrument. In
regime f, the central bank provides its forecasts (equivalently, its signals) directly to the public.11
In the absence of central bank announcements, firm j’s new information is given by its private
signals and the policy instrument. The new information available to firm j consists of Wj,t+1 and
qt . Assume beliefs about monetary policy are
θt = δ o Etcbψt +1 = δ o Γ cb Ωcb ,t +1 ,
where d 0 is 1 ¥ 3. These beliefs are consistent with a rational expectations equilibrium under
discretionary monetary policy.
Define Qo = [Q1o Q2o] such that Q1o is 3 ¥ 3 and Q2o is 3 ¥ 1, where the ijth element of Q1o gives
the effect of the firm’s jth signal on its forecast of the ith shock. Similarly, the ith element of Q2o
is the effect of qt on the firm’s forecast of the ith shock. Firm j’s expectation of Zt+1 is
Etj Zt+1 = Θ1oΩ j ,t +1 +Θo2θt .
Because the firm’s signals on the different shocks are uncorrelated, Q1o would, in the absence
of the observation of qt , consist of a diagonal matrix with signal-to-noise ratios along the diagonal. The off-diagonal elements of Q1o can be nonzero when the firm combines its own information with qt to forecast the shocks. For example, suppose qt > 0. This might indicate a response
by the central bank to a negative demand shock, a negative cost shock, or a positive welfare-gap
shock. If the firm’s signal on the demand shock is positive, then given qt , this makes it less likely
the central bank is reacting to a negative demand shock. The firm will therefore alter its forecast
of cost and target shocks.
As shown in the appendix, the equilibrium strategy for firm j will take the form
π *j ,t +1 = b1o Ω j ,t +1 + b2oθt ,
(5)
where b1o is 1 ¥ 3. Under both regimes, the expression for the coefficients on Wj,t+1 in the firm’s
equilibrium strategy takes the same form.12
The appendix shows also that the impact of the instrument on an individual firm’s pricing
decision is
(6)
1 − ωβ 1
b2o =
κ + (1 − ω ) b1o + (1 − ωβ ) (ι1 + κι 2 ) Θo2 ,
ω ω
where ii is a 3 ¥ 1 vector of zeros with a 1 in the ith place. Equation (6) illustrates the channels
through which a policy action affects the pricing decisions of firms. The first term, (1 – wb )k/w
is the standard effect operating through the output gap. Because inflation is (1 – w) times the
pricing decision of the individual firm in a standard New Keynesian model, the effect on aggregate inflation operating through this terms would be (1 – w) (1 – wb )k/w, which is the normal
coefficient on the output gap in a New Keynesian model based on Calvo pricing.
Federal Reserve Bank of St. Louis REVIEW
November/December 2013
585
Walsh
Figure 1
Elasticity of Inflation with Respect to the Policy Instrument in the Opaque Regime as a
Function of the Quality of Private Information
o
(1 – ω)*b 2
0.50
0.45
0.40
0.35
0.30
0.25
0.20
0.15
0.10
0.05
0
0.2
0.3
0.4
0.5
0.6
0.7
0.8
0.9
1.0
Signal-to-Noise Ratio for Private Information
NOTE: Solid line, g cbi = 0.5; dotted line, g cbi = 0.9.
The remaining terms on the right side in (6) represent the informational effects of policy
actions. For example, observing qt affects the firm’s expectations about cost, given by the term
(1 – wb )iiQ2o, and demand shocks, given by the term (1 – wb )kiiQ2o. Observing qt also affects
individual pricing decisions through the firm’s expectations of what other firms are expecting,
the (1 – w)b1o term.
Equilibrium inflation is given by
(7)
π t +1 = (1 − ω ) π t*+1 = (1 − ω ) (b1oΩt +1 + b2oθt )
and
∂π t+1
= (1 − ω ) b2o .
∂θt
The information channel can significantly affect the extent to which the central bank instrument impacts inflation. I calibrate the model by setting w = 0.65 (as a compromise between micro
evidence suggesting w on the order of 0.5 and time-series estimates typically on the order of 0.8),
b = 0.99, and k = 1.8. These values imply (1 – w) (1 – wb )k/w = 0.3455. The standard deviations
of all shocks are set equal to 1. Figure 1 shows how (1 – w)b2o varies with the quality of private
sector information, as measured by the signal-to-noise ratio, g ji. When firms have perfect infor586
November/December 2013
Federal Reserve Bank of St. Louis REVIEW
Centennial Issue
mation on the shocks (g ji = 1), the policy instrument, q, conveys no information and its effect on
inflation equals 0.3455, which is shown by the horizontal line in Figure 1.
However, when q conveys information (i.e., when g ji < 1), its impact on inflation is significantly reduced. Movements in q are partially attributed to the central bank’s response to the various shocks. A rise in q, for example, lowers firms’ forecasts of demand shocks. Because the net
v
effect on the expected output gap is qt + Ejiet+1
, the effect on price-setting behavior and inflation
is less than the change in q. A rise in q also leads firms to reduce their forecast of cost shocks,
partially offsetting the positive impact of a rise in q on inflation. For a given quality of private
sector information, the information channel becomes more important as central bank information improves and private firms place more weight on the information conveyed by policy actions.
The informational effects are larger, therefore, when the central bank has better quality informai
i
tion (in Figure 1, compare the solid line for g cb
= 0.5 with the dashed line for g cb
= 0.9).
Operating in a discretionary regime, the central bank sets policy optimally in each period
based on its current forecasts about the future state of the economy. The first-order condition
for minimizing the expected value of the central bank’s loss function (3) subject to (2) and (7) is
given in the appendix. This first-order condition can be solved for the optimal policy responses,
and their values are also given in the appendix.
The solution to the model is obtained numerically by beginning with initial values for the
policy coefficients, using these to obtain Qo, b1o, and b2o, and then obtaining new values for the
policy coefficients. This process continues until convergence. Once the equilibrium values of b1o
and b2o and the policy coefficients are obtained, aggregate inflation is given by
(b o + boδ o Γ ) ψ
1
2
cb
t +1
,
π t +1 = (1 − ω )
o o
+b2 δ Γ cbφcb ,t +1
whereas the welfare gap is given by
xt +1 − etu+1 = θt + etv+1 − etu+1 = δ o Γ cb Ωcb ,t +1 + (ι 2 − ι 3 ) Zt +1 = (δ oΓ cb + ι 2 −ι 3 ) Zt+1 + δ oΓ cbφcb ,t +1 .
Equilibrium Under a Transparent Regime
I interpret full transparency as a regime in which the central bank shares its information on
the economy. Within the context of the model, this would mean that the central bank publishes
its signals on the various disturbances so that Wcb,t+1 becomes known to all firms. Equivalently,
the central bank could publish its forecasts for inflation and the output gap. In a transparent
regime, the instrument is no longer a source of information to the private sector. This alters the
impact of qt on inflation and affects the central bank’s incentives for setting policy. When the
central bank provides its information to the public, the central bank information set is a subset
of the public information set. In this context, Svensson and Woodford (2003) have shown that
certainty equivalence holds and the policy decision of the central bank depends only on the
expected values of the shocks. In particular, this implies that the optimal policy will be independent of the quality of either central bank information or private sector information.
Federal Reserve Bank of St. Louis REVIEW
November/December 2013
587
Walsh
Let Q f = [Q1f Q2f ] be the appropriate 3 ¥ 6 coefficient matrix such that
Etj Zt+1 = Θ1f Ω j ,t +1 + Θ1f Ωcb ,t+1 .
The appendix shows that the equilibrium strategy for price-setting firms is
π *j ,t +1 = b1f Ω j ,t+1 + b2f θt + b3f Ωcb ,t+1 ,
where b1f takes the same form as b1o (except when Q1f replaces Q1o in the expression for b1f ).
Although the formula b1f is the same as for b1o, their values will differ as Q f ≠ Qo. The effects of
the central bank instrument and information are given by
b2f =
(1 − ωβ )
ω
κ
and
1
b3f = (1 − ω ) b1f + (1 − ωβ ) (ι1 + κι 2 ) Θ2f .
ω
*
, so
Inflation will equal (1 – w)p–t+1
∂π t+1
(1 − ω )(1 − ωβ )κ
= (1 − ω ) b2f =
∂θt
ω
and is independent of any informational effects. The exact expressions for the optimal policy
response to each type of signal are given in the appendix.
THE VALUE OF RELEASING INFORMATION
We can now compare the effects of providing information by comparing outcomes under
the opaque regime and the transparent regime. To assess outcomes under the two regimes, the
model is solved using the same calibrated parameters as employed earlier (i.e., w = 0.65, b = 0.99,
k = 1.8). I initially set the variances of all shocks equal to 1. For the loss function, I set lx = 1/16,
reflecting the use of quarterly inflation rates.
Table 1 shows the loss under each regime for different combinations of the signal-to-noise
ratios for both the private sector and the central bank. The first thing to note is the loss is increasing in the quality of private sector information (moving across rows from left to right) and decreasing in the quality of central bank information (comparing the top panel to the bottom panel).
Better private information makes expectations more sensitive to signals and so increases the
volatility of expectations. Greater volatility of expectations produces more inflation volatility.
This is welfare decreasing. Better central bank information is welfare improving because it allows
the central bank to engage in more effective stabilization policies that reduce the volatility of
inflation and the output welfare gap. Although Morris and Shin (2002) suggest that improved
commonly available information could reduce welfare, the results in Table 1 are consistent with
588
November/December 2013
Federal Reserve Bank of St. Louis REVIEW
Centennial Issue
Table 1
Loss Under Alternative Regimes (ss2 = sv2 = su2 = 1)
gji
i
g cb
0.2
0.4
0.6
0.8
1.0
= 0.5
Opaque regime
8.83
10.20
11.70
13.52
16.79
Transparent regime
9.52
10.33
11.49
13.35
16.79
p Equivalent
3.32
1.39
1.80
1.66
0
Opaque regime
4.56
5.55
6.50
7.21
7.64
Transparent regime
6.11
6.15
6.22
6.40
7.64
p Equivalent
4.97
3.08
2.11
3.60
0
i
g cb
= 0.9
NOTE: Bold indicates the regime with the least loss.
Hellwig (2004) and Svensson (2006), who argue that better quality central bank information
generally improves welfare.
When gji = 1, firms observe the true shocks perfectly. In this case, the release of information
or projections by the central bank is irrelevant and the loss is the same under both regimes, as
shown in the last column of Table 1. When private information is imperfect, loss differs under the
two regimes (the regime with the least loss is indicated in bold). The rows labeled “p equivalent”
express the reduction in loss under the optimal regime in terms of the reduction in average inflation (expressed at annual rates) that would yield a similar reduction in loss. For example, if
i
gji = 0.8 and gcb
= 0.5, the improvement of moving from an opaque regime to a transparent one
is equivalent to a reduction in inflation of 1.66 percentage points. The general results are similar
in both the top panel, when central bank information is relatively poor (the signal and the noise
i
have equal variances so that gcb
= 0.5), and the bottom panel, when central bank information is
i
relatively good (gcb = 0.9). What matters is the quality of private information. If this is low, then
the expectations of firms (and what individual firms expect that other firms are expecting) are
sensitive to any commonly available information released by the central bank.
The results in Table 1 are robust to different values for the variances of the underlying
shocks.13 The finding that transparency can lower welfare when private information is poor is
suggestive of the Morris and Shin (2002) argument that noisy public information can decrease
welfare. To investigate whether this is the effect that accounts for the relative performance of the
two regimes, one can calculate the sources of loss under each regime. From (4), loss arises from
inflation variability, welfare-gap variability, and relative price dispersion caused by heterogeneous
i
information. Table 2 shows each of these components for the case gcb
= 0.9, which corresponds
i
to the lower panel of Table 1 (results are similar for gcb = 0.5).
Table 2 reveals three differences between the equilibria for the opaque and transparent
regimes that are independent of the quality of private information. First, inflation is less volatile
Federal Reserve Bank of St. Louis REVIEW
November/December 2013
589
Walsh
Table 2
Components of Loss (ss2 = sv2 = su2 = 1)
gcbi = 0.9
gji
0.2
0.4
0.6
0.8
1.0
L
4.56
5.55
6.50
7.21
7.64
s p2
1.82
2.15
2.85
3.72
3.22
2 u
lxs x–e
1.68
1.71
1.84
2.20
4.42
lIs z2
1.07
1.70
1.81
1.30
0
L
6.11
6.15
6.22
6.40
7.64
s p2
1.66
1.66
1.67
1.73
3.22
2 u
lxs x–e
4.42
4.42
4.42
4.42
4.42
lIs z2
0.02
0.06
0.13
0.26
0
Opaque regime
Transparent regime
when policy is transparent. Second, the contribution of welfare-gap volatility to the overall loss
is much larger when policy is transparent. And third, the welfare cost of relative price dispersion is much smaller when policy is transparent. When gji is very low, opacity is the preferred
regime because the welfare gap is much more stable. As will be discussed further below, the
informational effects of policy actions are larger when the quality of private information is poor
and thus these effects distort the incentive of the central bank such that policy reacts too little to
cost shocks. This makes inflation more volatile but leaves the welfare gap more stable. Both
inflation and output-gap volatility in the opaque regime increase as gji rises, so that the transparent regime becomes preferred when private sector information is good.14
Table 3 shows the optimal policy responses to three central bank signals for gji equal to 0.4
i
equal to 0.5 and 0.9. Response coefficients in the transparent regime are indeand 0.8 and for gcb
pendent of the quality of both private sector and the central bank information. This result follows
from the demonstration by Svensson and Woodford (2003) that the central bank’s decision problem satisfies the conditions for certainty equivalence if the private sector has more information
than the central bank. This is the case in the transparent regime because the private sector knows
both the central bank signals and their own private signals. The way informational effects in the
opaque regime distort stabilization policy is clear from the muted response (in absolute value)
to signals on the cost shock and amplified response to signals on the welfare-gap shock. The
trade-off between inflation and welfare-gap volatility is clearly present—policy under the transparent regime responds more to stabilize inflation and, as a result, the welfare gap is more volatile,
as was shown in Table 2.
In addition, transparency allows the central bank to more efficiently neutralize the effects
of expected demand shocks. This can be seen by comparing the policy reaction coefficients
under the two regimes. Under the transparent regime, expected demand shocks are completely
590
November/December 2013
Federal Reserve Bank of St. Louis REVIEW
Centennial Issue
Table 3
Optimal Policy Coefficients (ss2 = sv2 = su2 = 1)
gji = 0.4
ds
dv
gji = 0.8
du
ds
dv
du
i
g cb
= 0.5
Opaque regime
–0.0947
–0.8884
0.7179
–0.2510
–0.9764
0.5246
Transparent regime
–0.3647
–1.0000
0.3436
–0.3647
–1.0000
0.3436
i
g cb
= 0.9
Opaque regime
–0.0816
–0.8944
0.7475
–0.1865
–0.9713
0.6356
Transparent regime
–0.3647
–1.0000
0.3436
–0.3647
–1.0000
0.3436
offset (i.e., d v = –1) regardless of the quality of private sector or central bank information. Under
the opaque regime, d v = –1 only when the public sector has perfect information on the shocks.
Otherwise, d v is less than 1 in absolute value and demand shocks are not fully offset.
Under the opaque regime, when the policy instrument is moved, the public will confuse
movements designed to offset forecasted demand shocks with movements designed to offset
either cost or welfare-gap shocks. As a consequence, movements aimed at offsetting demand
shocks can affect inflation expectations and cause actual inflation to fluctuate as the public
attributes part of the instrument change to the other shocks. This makes it optimal to not offset
demand shocks completely. Once the public can infer the central bank estimate of demand shocks,
as it can under transparency, there is no longer any reason not to fully react to insulate the output gap and inflation from projected demand shocks, so d 2v = –1.
In New Keynesian models, the welfare costs of inflation are the result of the relative price
dispersion that arises with staggered price adjustment. Heterogeneous information among firms
will also create relative price dispersion. Because information provided by the central bank is
common to all firms, it can help reduce relative price dispersion. Figure 2 shows the measure of
relative prices dispersion that results from heterogeneous information among firms. The solid
i
line with asterisks corresponds to the case of poor-quality central bank information (gcb
= 0.5)
under the opaque regime, and the unconnected asterisks correspond to the opaque regime with
high-quality central bank information (g cb = 0.9). The diamonds indicate the outcomes under
the transparent regime with poor-quality central bank information (the solid line) and highquality central bank information (the unconnected diamonds).
When gji = 1, all firms share the same information, so dispersion due to heterogeneous
information goes to zero under either policy regime. When firms have very poor-quality information (i.e., for low initial values of gji ) the heterogeneity of the information is high, but because
the information is of poor quality, firms do not respond strongly to it. As information quality
improves, firms react more strongly to their own private information and this increases price
dispersion. Hence, relative price dispersion is initially increasing in gji.
Now consider the role of quality central bank information under the opaque regime. Relative
price dispersion is lower when central bank information is good than when it is poor, though
Federal Reserve Bank of St. Louis REVIEW
November/December 2013
591
Walsh
Figure 2
Relative Price Dispersion Due to Heterogeneous Information
σ z2
0.15
0.10
Opaque Regime, γcb Low
Opaque Regime, γcb High
Transparent Regime, γcb Low
Transparent Regime, γcb High
0.05
0
0.2
0.3
0.4
0.5
0.6
0.7
0.8
0.9
1.0
Quality of Private Information
the loss from relative price dispersion actually constitutes a larger fraction of total social loss
when central bank information is good. This is the result of the better stabilization the central
bank can achieve when it has high-quality information on the economy. Not surprisingly, relative
price dispersion is always lower under the transparent regime. For the same reason, high-quality
central bank information reduces relative price dispersion under the transparent regime.
CONCLUSIONS
Under an opaque policy regime, where the private sector and the central bank do not share
the same information, policy actions become a source of information to the public. And these
policy actions have both direct effects on the output gap and indirect informational effects.
Under an opaque regime, however, certainty equivalence does not hold and information channels affect the central bank’s incentives. Optimal policy will depend on the quality of both central bank information and public information. In an opaque regime, the central bank stabilizes
inflation less and the welfare gap more than it would in a transparent regime.
Under a completely transparent regime, the public sector has access to the central bank
assessment of the economy. In this case, policy actions no longer provide any additional information. Optimal policy is independent of the quality of central bank information.
Consistent with the work of Svensson (2006) and Hellwig (2004), better central bank information was found to improve welfare. With better information, the central bank can implement more effective stabilization policies. The effect of providing more information by making
announcements about projected inflation and the output gap is more ambiguous. Transparency
always acts to lower relative price dispersion across firms by expanding the set of commonly
592
November/December 2013
Federal Reserve Bank of St. Louis REVIEW
Centennial Issue
available information, but central bank announcements can make expectations more volatile,
particularly if firms have relatively poor information. Transparency dominates opacity when
the private sector has relatively good information because in this case firms do not overreact to
the information contained in central bank announcements. However, if private sector information is poor, central bank announcements can reduce welfare. So although better central bank
information is desirable, more central bank information may not be. ■
APPENDIX
Welfare Weight on Information Dispersion
The welfare loss in New Keynesian models arises from inefficient price dispersion across
–
firms. Let pj,t denote firm j’s price and let Pt be the aggregate price level. Then
∆t ≡ varj ( log p j ,t − Pt −1 )
= Et ( log p j ,t − Pt −1 ) − ( Et log p j ,t − Pt −1 )
2
2
= Et ( log p j ,t − Pt −1 ) − ( Pt − Pt −1 ) .
2
2
Using the assumptions of the Calvo model, the first term on the right can be written as
Et ( log p j ,t −1 − Pt −1 ) + (1 − ω ) Et ( log p*j ,t − log Pt −1) = ω ∆t −1 + (1 − ω ) Et ( log p*j ,t − Pt −1 ) .
2
2
2
Now
log p*j ,t − P t −1 = log p*j ,t − log pt* + log pt* − Pt −1 ,
where the first term on the right is zero in the standard New Keynesian model with common
information across firms. Hence,
Et ( log p*j ,t − Pt −1 ) = Et ( log p*j ,t − log pt* ) + ( log pt* − Pt −1 )
2
2
2
because the idiosyncratic noise is independent of the fundamental shocks. From the definition
of inflation,
π t = (1 − ω ) ( log pt* − Pt −1 ) ,
so
2
2
2 1
Et ( log p*j ,t − Pt −1 ) = Et ( log p*j ,t − log pt* ) +
π 2.
1 −ω t
Federal Reserve Bank of St. Louis REVIEW
November/December 2013
593
Walsh
Combining these results,
2 1 2
∆t = ω ∆t −1 + (1 − ω ) Et ( log p*j ,t − log pt* ) +
π t − π t2
1 −ω
2 ω 2
= ω ∆t −1 + (1 − ω ) Et ( log p*j ,t − log pt* ) +
π .
1 −ω t
It follows that
∞
Et
∑
i =0
ω 1
β i ∆t +i =
E
1 − ω 1 − ωβ t
∞
∑ β π
i
2
t +i
2
+ λI ( log p*j ,t +i − log pt*+i) ,
i=0
where
λ I = (1 − ω ) / ω .
2
The Opaque Regime
Let
2
0
0
σs
Σ = 0 σ v2 0
0 σ u2
0
Σ
j
2+ 2
σ s σ j ,s
=
0
0
,
0
0
σ v2 + σ 2j ,v
0
0
σ u2 + σ 2j ,u
,
and
σ 2 +σ 2
cb ,s
s
Σcb = 0
0
0
0
σ v2 + σ cb2 ,v
0
0
σ u2 + σ cb2 ,u
.
In the absence of central bank announcements, firm j’s new information is given by
s
s
et +1 + φ j ,t+1
ev +φ v
t +1 j ,t+1
eu + φ u
t +1 j ,t+1
θt
Ω
= j ,t+1
θt
,
where
θt = δ o Γ cb Ωcb ,t +1 .
594
November/December 2013
Federal Reserve Bank of St. Louis REVIEW
Centennial Issue
Define
Θo = Σ ΣΓ′cbδ o′
ΣΓ′cbδ o′
Σj
δ o Γ Σ δ o Γ Σ Γ′ δ o ′
cb
cb cb cb
−1
= Θ1o
Θo2 ,
where Q1o is 3 ¥ 3 and Q2o is 3 ¥ 1. Thus, firm j’s expectation of Zt+1 is
Etj Zt+1 = Θ1oΩ j ,t +1 +Θo2θt = Θ1o Ω j ,t +1 + Θo2δ oΓ cb Ωcb ,t +1 .
The aggregate information (i.e., aggregated across all firms) is
Ω
t +1
θt
=
ets+1
etv+1 Zt +1
=
u
et +1 θt
θt
.
Defining ii as a 1 ¥ 3 vector with a 1 in the ith place and zeros elsewhere, we can write (1), a
firm’s price adjustment, as
ωβ j
π *j ,t +1 = (1 − ω ) Etj π t*+1 + (1 − ωβ ) κθt + (1 − ωβ ) (ι1 + κι 2 ) Etj Zt +1 +
E π
1 − ω t t+2
ωβ j
= (1 − ω ) Etj π t*+1 + (1 − ωβ ) κθt + (1 − ωβ ) (ι1 + κι 2 ) ( Θ1oΩ j ,t +1 +Θo2θt ) +
E π .
1 − ω t t +2
An equilibrium strategy for firm j will take the form
π *j ,t +1 = b1o Ω j ,t +1 + b2oθt ,
where b1o is 1 ¥ 3.
In forming expectations about the pricing behavior of other firms adjusting in the current
*
is given by
period, firm j’s expectation of p–t+1
Etj π t*+1 = b1o Etj+1Ωt +1 + b2oθt
= b1o Etj+1 Zt +1 + b2oθt
= b1o Θ1oΩ j ,t +1 +Θ2oθt + b2oθt
= b1o Θ1o Ω j ,t +1 + (b1oΘo2 + b2o ) θt .
Because
π t +1 = (1 − ω ) π t*+1 ,
it follows that
Etj π t +2 = (1 − ω ) Etj π t*+2
= (1 − ω ) Etj b1o Θ1o Ω j ,t +2 + (b1oΘo2 + b2o ) θt+1 = 0.
Federal Reserve Bank of St. Louis REVIEW
November/December 2013
595
Walsh
Substituting these into the equation for p*j,t+1 and collecting terms,
π *j ,t +1 = (1 − ω ) b1oΘ1o Ω j ,t +1 + (1 − ωβ ) (ι1 + κι 2 ) Θ1o Ω j ,t +1
+ (1 − ωβ ) κθt + (1 − ω ) (b1o Θo2 + b2o )θt
+ (1 − ωβ ) (ι1 + κι 2 ) Θo2θt .
Equating coefficients with the proposed solution yields
−1
b1o = (1 − ωβ ) (ι1 + κι 2 )Θ1o I3 − (1 − w ) Θ1o .
The expression for b2o is reported in the text.
The objective function under discretion involves minimizing
2
Etcb π t2+1 + λx ( xt +1 − etu+1 )
subject to (2) and (7). The first-order condition for the central bank decision problem under
discretion is
(1 − ω ) bθ Etcb π t+1 + λ x (θt + Etcb etv+1 − Etcb etu+1 ) = 0.
From (7),
Etcb π t +1 = (1 − ω ) b1o Etcb Ω j ,t +1 + (1 − ω ) b2oθt
= (1 − ω ) b1oΓ cb Ωcb ,t+1 + (1 − ω ) b2oθt
because
Etcb Ω j ,t +1 = Etcb Zt +1 = Γ cb Ωcb ,t +1 .
Hence, the first-order condition becomes
cb v
λ + (1 − ω ) 2 b o 2 θ = (1 − ω ) b o E cb e u − (1 − ω ) 2 b ob oΓ Ω
( 2) t
2 t t +1
2 1 cb cb ,t +1 − λ x Et et +1 .
x
This in turn implies that
( ) θ
λ + (1 − ω )2 b o
2
x
2
t
= − (1 − w ) b2ob1o Γcb Ωcb ,t +1
2
+ 0
− λx
(1 − ω )b2o
Γ cb Ωcb,t +1 .
Hence,
θt = δ o Γ cb Ωcb ,t +1 ,
where d o = [d s d v d u] and
596
November/December 2013
Federal Reserve Bank of St. Louis REVIEW
Centennial Issue
(8)
2
(1 − ω ) b2ob11o
δ s = −
λ + (1 − ω )2 (b o )2
2
x
(9)
2
λ x + (1 − ω ) b2ob12o
δ =−
λ + (1 − ω ) 2 (bo ) 2
2
x
v
2
λ − (1 − ω ) b2ob13o
.
δu = x
λx + (1 − ω )2 (b2o )2
The Transparent Regime
In regime f, the central bank announces its signals so that firms observe Wcb,t+1 directly.
Firms’ expectations now depend on Wcb,t+1 and not directly on qt .
Guess an equilibrium strategy of the form
π ∗j ,t +1 = b1f Ω j ,t+1 + b2f Ωcb ,t +1 + b3f θt .
Then, following the same procedures as used to solve the model without announcements, one
finds that
b1f = (1 − ωβ ) (ι1 + κι 2 )Θ1f I3 − (1 − ω ) Θ1f
−1
1
b2f = (1 − ω ) b f + (1 − ωβ ) (ι1 + κι 2 )Θ2f .
ω
b3f =
(1 − ωβ ) κ .
ω
Optimal policy in this regime satisfies the first-order condition
(1 − ω ) b3f Etcb π t +1 + λx (θt + Etcb etv+1 − Etcb etu+1 ) = 0.
Note that
Etcb π t+1 = (1 − ω ) (b1f Γ cb + b2f ) Ωcb ,t +1 + b3f θt
because
Etcb Ω j ,t +1 = Γ cb Ωcb ,t +1 .
Solving the first-order condition yields
θt = d f Γ cb Ωcb ,t+1 ,
Federal Reserve Bank of St. Louis REVIEW
November/December 2013
597
Walsh
with d f = [d s d v d u] and
b f / γ s +b f
( 21 cb ) 11
2
d s = − (1 − ω ) b3f
λ + ( h f )2 (1 − w )2
x
λ + (1 − ω ) 2 b f b f / γ v + b f
12
x
cb )
3 ( 22
v
d = −
2
2
f
1
λ
+
−
ω
b
( 3) ( )
x
λ − (1 − ω )2 b f b f / γ u + b f
x
cb )
13
3 ( 23
u
.
d =
2
2
f
λx + (b3 ) (1 − ω )
NOTES
1
“Even as Wall Street analysts ratchet up their worries about a recession, Fed officials are far from convinced that a
true downturn is likely” (Andrews, 2007). A more vivid example of disagreement was provided by CNBC commentator Jim Cramer, whose blast that the Fed is clueless about “how bad it is out there” was reportedly seen by more than
a million viewers on YouTube.
2
See Eijffinger and Geraats (2006) and Dincer and Eichengreen (2007) for indices of central bank transparency.
Cukierman (2006) discusses some of the factors that might place limits on how transparent central banks should (or
can) be.
3
As Tim Harford (2007, Part 2, p. 3) pointed out in a recent “Dear Economist” column in the Financial Times, it might
seem sensible for a company to judge its ice cream sales force on total sales, but having information about the
weather allows for a better assessment of the contribution of the sales team to actual sales.
4
Italics in the original.
5
See, for example, Cukierman and Meltzer (1986) and Faust and Svensson (2002).
6
See also Faust and Svensson (2002), who show that, when the choice of transparency is made under commitment,
patient central banks with small inflation biases will prefer minimum transparency. They argue that this result might
account for the (then) relatively low degree of transparency that characterized the U.S. Federal Reserve System.
7
Goodhart (2006).
8
Woodford (2003) has investigated the role of higher-order expectations in inducing persistent adjustments to monetary shocks in the Lucas-Phelps islands model. See also Hellwig (2002).
9
In Walsh (2007b), I show that this incentive effect under discretion can make it socially optimal to appoint a Rogoffconservative central banker, that is, a central banker who places less weight on output-gap stabilization than society
does.
10 As noted earlier, in the basic Morris-Shin model, Svensson (2006) shows that for almost all parameter values, better
central bank information is welfare improving.
11 Alternatively, the central bank could announce its inflation and output-gap forecasts; combined with the observed
instrument setting, these announcements would fully reveal the central bank’s signals.
12 Of course, their values differ under the two regimes to the extent that the information available to firms differs.
13 For each s 2, the value was changed between 2 and 0.01, whereas the other variances were held fixed at 1.
i
14 Also apparent in Table 2 is that, in the transparent regime, the volatility of the welfare gap is independent of the
quality of private sector information. This reflects the certainty equivalence property that characterizes the policy
choice of the central bank in the transparent regime. The central bank’s setting of its instrument is independent of g ji
and, as a result, so is the behavior of the output and welfare gaps.
598
November/December 2013
Federal Reserve Bank of St. Louis REVIEW
Centennial Issue
REFERENCES
Amato, Jeffrey D. and Shin, Hyun Song. “Public and Private Information in Monetary Policy Models.” Working Paper
No. 138, Bureau of Labor Statistics, September 2003.
Andrews, Edmund L. “Bad News Puts Political Glare Onto Economy.” New York Times, September 8, 2007;
http://www.nytimes.com/2007/09/08/business/08policy.html.
Atkins, Ralph; Mackenzie, Michael and Davies, Paul J. “ECB Chief Fails to Reassure Markets.” Financial Times, August 15,
2007, p. 1.
Bernanke, Ben S. “The Recent Financial Turmoil and its Economic and Policy Consequences.” Presented at the
Economic Club of New York, New York, NY, October 15, 2007.
Blinder, Alan S. “Monetary Policy Today: Sixteen Questions and About Twelve Answers.” Presented at the Banco de
España conference Central Banks in the 21st Century, June 2006.
Christiano, Lawrence J.; Eichenbaum, Martin and Evans, Charles. “Nominal Rigidities and the Dynamic Effects of a
Shock to Monetary Policy.” Journal of Political Economy, 2005, 113(1), 1-45.
Cornand, Camille and Heinemann, Frank. “Optimal Degree of Public Information Dissemination.” Working Paper
No. 1353, CESifo, December 2004.
Cukierman, Alex. “The Limits of Transparency.” Presented at the session “Monetary Policy Transparency and
Effectiveness” at the American Economic Association, January 2006.
Cukierman, Alex and Meltzer, Allan H. “A Theory of Ambiguity, Credibility, and Inflation under Discretion and
Asymmetric Information.” Econometrica, September 1986, 54(5): pp. 1099-128.
Dincer, Nergiz N. and Eichengreen, Barry. “Central Bank Transparency: Where, Why, and With What Effects?” NBER
Working Paper No. 13003, National Bureau of Economic Research, March 2007.
Eijffinger, Sylvester C.W. and Geraats, Petra M. “How Transparent Are Central Banks?” European Journal of Political
Economy, March 2006, 22(1), pp. 1-21.
Faust, Jon and Svensson, Lars E.O. “The Equilibrium Degree of Transparency and Control in Monetary Policy.” Journal of
Money, Credit, and Banking, May 2002, 34(2), pp. 520-39.
Geraats, Petra M. “Central Bank Transparency.” Economic Journal, November 2002, 112(483), pp. 532-65.
Geraats, Petra M. “Transparency and Reputation: The Publication of Central Bank Forecasts.” Topics in Macroeconomics,
2005, 5(1), pp. 1-26.
Goodhart, Charles A.E. “Letter to the Editor.” Financial Times, June 29, 2006.
Gosselin, Pierre; Lotz, Aileen and Wyplosz, Charles. “The Expected Interest Rate Path: Alignment of Expectations vs.
Creative Opacity Should Central Banks Reveal Expected Future Interest Rates?” International Journal of Central
Banking (forthcoming).
Guha, Krishna. “Debate Unfolds on Likely Impact of Cut in US Interest Rates.” Financial Times, September 6, 2007, p. 2.
Harford, Tim. “Dear Economist.” Financial Times, September 1, 2007, Part 2, p. 3.
Hellwig, Christian. “Public Announcements, Adjustment Delays and the Business Cycle.” UCLA, November 2002.
Hellwig, Christian. “Heterogeneous Information and the Benefits of Transparency.” UCLA, December 2004.
Morris, Stephen and Shin, Hyun Song. “Social Value of Public Information.” American Economic Review, December 2002,
92(5), pp. 1521-34.
Poole, William. “Communicating the Fed’s Policy Stance.” Presented at the HM Treasury/GES conference Is There a New
Consensus in Macroeconomics? London, November 30, 2005;
http://fraser.stlouisfed.org/docs/historical/frbsl_history/presidents/poole/20051130.pdf.
Poole, William. “Fed Communications.” Presented to the St. Louis Forum, February 24, 2006;
http://fraser.stlouisfed.org/docs/historical/frbsl_history/presidents/poole/20060224.pdf.
Federal Reserve Bank of St. Louis REVIEW
November/December 2013
599
Walsh
Rotemberg, Julio J. and Woodford, Michael. “An Optimizing-Based Econometric Model for the Evaluation of Monetary
Policy,” in Ben S. Bernanke and Julio J. Rotemberg, eds., NBER Macroeconomic Annual 1997. Cambridge, MA: MIT
Press, 1997, pp. 297-346.
Rudebusch, Glenn D. and Williams, John C. “Revealing the Secrets of the Temple: The Value of Publishing Central Bank
Interest Rate Projections.” October 2006; also in J.Y. Campbell, ed., Asset Prices and Monetary Policy. Chicago:
University of Chicago Press (forthcoming).
Svensson, Lars E.O. “Social Value of Public Information: Morris and Shin (2002) Is Actually Pro Transparency, Not Con.”
American Economic Review, March 2006, 96(1), pp. 448-51.
Svensson, Lars E. O. and Woodford, Michael. “Optimal Policy With Partial Information in a Forward-Looking Model:
Certainty-Equivalence Redux.” NBER Working Paper No. w9430. National Bureau of Economic Research, January
2003.
Walsh, Carl E. “Announcements, Inflation Targeting and Central Bank Incentives.” Economica, May 1999, 66(262), pp.
255-69.
Walsh, Carl E. “Transparency, Flexibility, and Inflation Targeting,” in Frederic Mishkin and Klaus Schmidt-Hebbel, eds.,
Monetary Policy Under Inflation Targeting. Santiago, Chile: Banco Central de Chile, 2007a.
Walsh, Carl E. “Optimal Economic Transparency.” International Journal of Central Banking. March 2007b, 3(1), pp. 5-30.
Woodford, Michael. Money, Interest, and Prices, Princeton: Princeton University Press, 2003.
Woodford, Michael. “Central Bank Communications and Policy Effectiveness.” Presented at the Federal Reserve Bank of
Kansas City symposium The Greenspan Era: Lessons for the Future, Jackson Hole, WY, August 2005.
Yellen, Janet L. “Policymaking on the FOMC: Transparency and Continuity.” Federal Reserve Bank of San Francisco
Economic Letter, No. 2005-22, September 2, 2005.
600
November/December 2013
Federal Reserve Bank of St. Louis REVIEW
Centennial Issue
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.
This article first appeared in the May/June 2007 issue of Review.
Federal Reserve Bank of St. Louis Review, November/December 2013, 95(6), pp. 601-11.
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.
O
At the time this article was written, William Poole was the president of the Federal Reserve Bank of St. Louis. The author had thanked his
colleagues at the Federal Reserve Bank of St. Louis. William R. Emmons, senior economist, provided special assistance.
This article has been reformatted since its original publication in Review: Poole, William. “The GSEs: Where Do We Stand?” Federal Reserve Bank of
St. Louis Review, May/June 2007, 89(3), pp. 143-51; http://research.stlouisfed.org/publications/review/07/05/Poole.pdf.
© 2013, The Federal Reserve Bank of St. Louis. The views expressed in this article are those of the author(s) and do not necessarily reflect the views
of the Federal Reserve System, the Board of Governors, or the regional Federal Reserve Banks. 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.
Federal Reserve Bank of St. Louis REVIEW
November/December 2013
601
Poole
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 environment 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 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
602
November/December 2013
Federal Reserve Bank of St. Louis REVIEW
Centennial Issue
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 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-a-half 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 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.
Federal Reserve Bank of St. Louis REVIEW
November/December 2013
603
Poole
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 low-key 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 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.
604
November/December 2013
Federal Reserve Bank of St. Louis REVIEW
Centennial Issue
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.
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
combined 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
10-year 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
Federal Reserve Bank of St. Louis REVIEW
November/December 2013
605
Poole
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 well-capitalized 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 federal
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 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
606
November/December 2013
Federal Reserve Bank of St. Louis REVIEW
Centennial Issue
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 [Government Accountability Office] 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.
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
Federal Reserve Bank of St. Louis REVIEW
November/December 2013
607
Poole
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.
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. ■
608
November/December 2013
Federal Reserve Bank of St. Louis REVIEW
Centennial Issue
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 financialsystem 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.
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-thecounter 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.
Federal Reserve Bank of St. Louis REVIEW
November/December 2013
609
Poole
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.
NOTES
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.
2
For a more detailed discussion of this topic, see Poole (2005).
3
See http://www.ofheo.gov/media/pdf/capclass93004.pdf.
4
For a discussion of Federal Reserve emergency powers, see Poole (2004).
5
Most recently, the GAO criticized GSE oversight in Walker (2005).
6
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).
REFERENCES
Board of Governors of the Federal Reserve System (Parkinson, Patrick and Gibson, Michael) and 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;
http://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;
http://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;
http://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.
610
November/December 2013
Federal Reserve Bank of St. Louis REVIEW
Centennial Issue
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 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;
http://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; http://www.fha.gov/webfiles/1145/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 Government-Sponsored Enterprises
on Mortgage Rates.” Real Estate Economics, Fall 2005, 33(3), pp. 427-63;
http://www.federalreserve.gov/pubs/feds/2005/200506/200506pap.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;
http://fraser.stlouisfed.org/docs/historical/frbsl_history/presidents/poole/20011018.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;
http://fraser.stlouisfed.org/docs/historical/frbsl_history/presidents/poole/20040506.pdf.
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;
http://www.gao.gov/new.items/d05576t.pdf.
Federal Reserve Bank of St. Louis REVIEW
November/December 2013
611
612
November/December 2013
Federal Reserve Bank of St. Louis REVIEW
Centennial Issue
Seven Faces of “The Peril”
James Bullard
In this paper the author discusses the possibility that the U.S. economy may become enmeshed in a
Japanese-style deflationary outcome within the next several years. To frame the discussion, the author
relies on an analysis that emphasizes two possible long-run steady states for the economy: one that is
consistent with monetary policy as it has typically been implemented in the United States in recent years
and one that is consistent with the low nominal interest rate, deflationary regime observed in Japan during the same period. The data considered seem to be quite consistent with the two steady-state possibilities. The author describes and critiques seven stories that are told in monetary policy circles regarding
this analysis and emphasizes two main conclusions: (i) The Federal Open Market Committee’s “extended
period” language may be increasing the probability of a Japanese-style outcome for the United States and
(ii), on balance, the U.S. quantitative easing program offers the best tool to avoid such an outcome.
(JEL E4, E5)
This article first appeared in the September/October 2010 issue of Review.
Federal Reserve Bank of St. Louis Review, November/December 2013, 95(6), pp. 613-28.
THE PERIL
n 2001, three academic economists published a paper entitled “The Perils of Taylor Rules.”1
The paper has vexed policymakers and academics alike, as it identified an important and
very practical problem—a peril—facing monetary policymakers, but provided little in the
way of simple resolution. The analysis appears to apply equally well to a variety of macroeconomic frameworks, not just to those in one particular camp or another, so that the peril result
has great generality. And, most worrisome, current monetary policies in the United States (and
possibly Europe as well) appear to be poised to head straight toward the problematic outcome
described in the paper.
I
James Bullard is president and CEO of the Federal Reserve Bank of St. Louis. Any views expressed are his own and do not necessarily reflect the
views of other Federal Open Market Committee members. The author benefited from review and comments by Richard Anderson, David
Andolfatto, Costas Azariadis, Jess Benhabib, Cletus Coughlin, George Evans, William Gavin, Seppo Honkapohja, Narayana Kocherlakota, Michael
McCracken, Christopher Neely, Michael Owyang, Adrian Peralta-Alva, Robert Rasche, Daniel Thornton, and David Wheelock. Marcela M. Williams
provided outstanding research assistance.
This article has been reformatted since its original publication in Review: Bullard, James. “Seven Faces of ‘The Peril’.” Federal Reserve Bank of St. Louis
Review, September/October 2010, 92(5), pp. 339-52; http://research.stlouisfed.org/publications/review/10/09/Bullard.pdf.
© 2013, The Federal Reserve Bank of St. Louis. The views expressed in this article are those of the author(s) and do not necessarily reflect the views
of the Federal Reserve System, the Board of Governors, or the regional Federal Reserve Banks. 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.
Federal Reserve Bank of St. Louis REVIEW
November/December 2013
613
Bullard
Figure 1
Interest Rates and Inflation in Japan and the U.S.
Nominal Interest Rate (percent)
Japan, Jan. 2002 to May 2010
5
U.S., Jan. 2002 to May 2010
4
Fisher Relation
Nonlinear Taylor-Type Rule
(2.3, 2.8)
3
2
2003-2004
1
(–0.5, 0.001)
May 2010
May 2010
0
–2.00
–1.50
–1.00
–0.50
0.00
0.50
1.00
1.50
2.00
2.50
3.00
Inflation (percent)
NOTE: Short-term nominal interest rates and core inflation rates in Japan and the United States, 2002-10.
SOURCE: Data from the Organisation for Economic Co-operation and Development.
The authors of the 2001 paper—Jess Benhabib at New York University and Stephanie
Schmitt-Grohé and Martín Uribe both now at Columbia University—studied abstract economies
in which the monetary policymaker follows an active Taylor-type monetary policy rule—that is,
the policymaker changes nominal interest rates more than one for one when inflation deviates
from a given target. Active Taylor-type rules are so commonplace in present-day monetary policy
discussions that they have ceased to be controversial. Benhabib, Schmitt-Grohé, and Uribe also
emphasized the zero bound on nominal interest rates. They suggested that the combination of
an active Taylor-type rule and a zero bound on nominal interest rates necessarily creates a new
long-run outcome for the economy. This new long-run outcome can involve deflation and a very
low level of nominal interest rates. Worse, there is presently an important economy that appears
to be stuck in exactly this situation: Japan.
To see what these authors were up to, consider Figure 1. This is a plot of nominal interest
rates and inflation for both the United States and Japan during the period from January 2002
through May 2010. The frequency is monthly. The Japanese data are the circles in the figure, and
the U.S. data are the squares. The short-term nominal interest rate is on the vertical axis, and
the inflation rate is on the horizontal axis. To maintain as much international comparability as
possible, all data are from the Organisation for Economic Co-operation and Development
(OECD) main economic indicators (MEI). The short-term nominal interest rate is taken to be
the policy rate in both countries—the overnight call rate in Japan and the federal funds rate in
614
November/December 2013
Federal Reserve Bank of St. Louis REVIEW
Centennial Issue
the United States. Inflation in the figure is the core consumer price index inflation rate measured
from one year earlier in both countries. The data in the figure never mix during this time period:
The U.S. data always lie to the northeast, and the Japanese data always lie to the southwest. This
will be an essential mystery of the story.
Benhabib, Schmitt-Grohé, and Uribe (2001) wrote about the two lines in the figure. The
dashed line represents the famous Fisher relation for safe assets—the proposition that a nominal
interest rate has a real component plus an expected inflation component. I have taken the real
component (also the rate of time preference in the original analysis by Benhabib, Schmitt-Grohé,
and Uribe) to be fixed and equal to 50 basis points in the figure.2 Practically speaking, any macroeconomic model of monetary phenomena will have a Fisher relation as a part of the analysis, and
so this line is hardly controversial. The solid line in the figure represents a Taylor-type policy rule:
It describes how the short-term nominal interest rate is adjusted by policymakers in response to
current inflation. In the right half of the figure, when inflation is above target, the policy rate is
increased, but more than one for one with the deviation of inflation from target. And when
inflation is below target, the policy rate is lowered, again more than one for one. When the line
describing the Taylor-type policy rule crosses the Fisher relation, we say there is a steady state at
which the policymaker no longer wishes to raise or lower the policy rate, and, simultaneously,
the private sector expects the current rate of inflation to prevail in the future. It is an equilibrium
in the sense that, if there are no further shocks to the economy, nothing will change with respect
to inflation or the nominal interest rate. In the figure, this occurs at an inflation rate of 2.3 percent
and a nominal interest rate of 2.8 percent (denoted by an arrow on the right side of the figure).
This is sometimes called the “targeted” steady state.3
The “active” policy rule—the fact that nominal interest rates move more than one for one
with inflation deviations in the right half of the figure—is supposed to keep inflation near the
target. It also means that the line describing the Taylor-type policy rule is steeper than the line
describing the Fisher relation in the neighborhood of the targeted inflation rate. It cuts the Fisher
relation from below. Taken at face value, the Taylor-type policy rule has been fairly successful
for the United States: Inflation (by this measure) has been neither above 3 percent nor, until very
recently, below 1 percent during the January 2002–May 2010 period.
None of this so far is really the story told by Benhabib, Schmitt-Grohé, and Uribe. On the
right-hand side of the figure, short-term nominal interest rates are adjusted up and down to keep
inflation low and stable. It’s all very conventional. The point of the analysis by Benhabib, SchmittGrohé, and Uribe is to think more carefully about what these seemingly innocuous assumptions—
the Fisher relation, the active Taylor-type rule, the zero bound on nominal interest rates—really
imply as we move to the left in the figure, far away from the targeted steady-state equilibrium.
And, what these building blocks imply is only one thing: The two lines cross again, creating a
second steady state. In the figure, this second steady state occurs at an inflation rate of –50 basis
points and an extremely low short-term nominal interest rate of about one-tenth of a basis point
(see the arrow on the left side of the figure).4 The Japanese inflation data are all within about
100 basis points of this steady state, between –150 basis points and 50 basis points. That’s about
the same distance from low to high as the U.S. inflation data. But for the nominal interest rate,
most of the Japanese observations are clustered between 0 and 50 basis points. The policy rate
Federal Reserve Bank of St. Louis REVIEW
November/December 2013
615
Bullard
cannot be lowered below zero, and there is no reason to increase the policy rate since—well, inflation is already “too low.” This logic seems to have kept Japan locked into the low nominal interest
rate steady state. Benhabib, Schmitt-Grohé, and Uribe sometimes call this the “unintended”
steady state.5
At the unintended steady state, policy is no longer active: It has instead switched to being
passive. The policy line crosses the Fisher relation from above. When inflation decreases, the
policy rate is not lowered more than one for one because of the zero lower bound. And when
inflation increases, the policy rate is not increased more than one for one because, in this region
of the diagram, inflation is well below target. Fluctuations in inflation are in fact not met with
much of a policy response at all in the neighborhood of the unintended steady state. At this steady
state, the private sector has come to expect the rate of deflation consistent with the Fisher relation accompanied by very little policy response; thus, nothing changes with respect to nominal
interest rates or inflation. Where does policy transition from being active to being passive? This
occurs when the slope of the nonlinear Taylor-type rule is exactly 1, which is at an inflation rate
of about 1.56 percent in Figure 1.
Again, the data in this figure do not mix at all—it’s boxes on the right and circles on the left.
But the most recent observation for the United States, the solid box labeled “May 2010,” is about
as close as the United States has been in recent times to the low nominal interest rate steady state.
It is below the rate at which policy turns passive in the diagram. In addition, the Federal Open
Market Committee (FOMC) has pledged to keep the policy rate low for an “extended period.”
This pledge is meant to push inflation back toward target—certainly higher than where it is
today—thus moving to the right in the figure. Still, as the figure makes clear, pledging to keep
the policy rate near zero for such a long time would also be consistent with the low nominal
interest rate steady state, in which inflation does not return to target but instead both actual
and expected inflation turn negative and remain there. Furthermore, we have an example of an
important economy that appears to be in just this situation.
A key problem in the figure is that the monetary policymaker uses only nominal interest
rate adjustment to implement policy. This is the meaning of the nonlinear Taylor-type policy
rule continuing far to the left in the diagram. The policymaker is completely committed to interest rate adjustment as the main tool of monetary policy, even long after it ceases to make sense
(long after policy becomes passive), creating a second steady state for the economy. Many of the
responses described below attempt to remedy the situation by recommending a switch to some
other policy when inflation is far below target. The regime switch required must be sharp and
credible—policymakers have to commit to the new policy and the private sector has to believe
the policymakers. Unfortunately, in actual policy discussions nothing of this sort seems to be
happening. Both policymakers and private sector players continue to communicate in terms of
interest rate adjustment as the main tool for the implementation of monetary policy. This is
increasing the risk of a Japanese-style outcome for the United States.
My view is that the 2001 analysis by Benhabib, Schmitt-Grohé, and Uribe is an important
one for current policy, that it has garnered insufficient attention in the policy debate, and that it
is indeed closely related to the current “extended period” pledge of the FOMC. Below I relate
and critique seven stories—both formal ones and informal ones—that I have encountered con616
November/December 2013
Federal Reserve Bank of St. Louis REVIEW
Centennial Issue
Figure 2
Denial
Nominal Interest Rate (percent)
6
5
4
(2.3, 2.8)
3
2
2003-2004
1
May 2010
0
0.50
1.00
1.50
2.00
2.50
3.00
–1
U.S., Jan. 2002 to May 2010
–2
Fisher Relation
Linear Taylor-Type Rule
–3
Inflation (percent)
cerning this analysis. The fact that there are seven “faces” shows just how fragmented the economics profession is on this critical issue. These stories range from reasons not to worry about
the implications of Figure 1, through ways to adjust nominal interest rates to avoid the implications of Figure 1, and on to the uses of unconventional policies as a tool to avoid “the peril.”
I conclude that promises to keep the policy rate near zero may be increasing the risk of falling
into the unintended steady state of Figure 1 and that an appropriate quantitative easing policy
offers the best hope for avoiding such an outcome.
SEVEN FACES
Denial
I think it is fair to say that, for many who have been involved in central banking over the
past two or three decades, it is difficult to think of Japan and the United States in the same game,
as Figure 1 suggests. For many, the situation in Japan since the 1990s has been a curiosum, an
odd outcome that might be chalked up to particularly Byzantine Japanese politics, the lack of an
inflation target for the Bank of Japan (BOJ), a certain lack of political independence for the BOJ,
or some other factor specific to the Land of the Rising Sun. The idea that U.S. policymakers should
worry about the nonlinearity of the Taylor-type rule and its implications is sometimes viewed as
an amusing bit of theory without real ramifications. Linear models tell you everything you need
to know. And so, from this denial point of view, we can stick with our linear models and ignore
the data from Japan (Figure 2).
Federal Reserve Bank of St. Louis REVIEW
November/December 2013
617
Bullard
In Figure 2, the targeted steady state remains at an inflation rate of 2.3 percent, but the
Taylor-type rule is now linear. The policy rate still reacts to the current level of inflation, and
more than one for one; that is, the Taylor-type rule is still active. In fact, in the neighborhood of
the targeted steady state, there would be very little difference in choosing the linear or the nonlinear versions of the Taylor-type rule. For lower values of inflation, however, the linear Taylortype rule now extends into negative territory, violating the zero bound on nominal interest rates.
Some contemporary discussion of monetary policy pines for a negative policy rate exactly as
pictured here. One often hears that, given the state of today’s economy, the desired policy rate
would be, say, –6.0 percent, as suggested by the chart. This is nonsensical, since under current
operating procedures such a policy rate is infeasible and therefore we cannot know how the
economy would behave with such a policy rate.6
The most disturbing part of Figure 2, however, is that the Japanese data are not part of the
picture. This tempts one to argue that, because core inflation is currently below target, there is
little harm in keeping the policy rate near zero and, indeed, in promising to keep the policy rate
near zero in the future. There is no danger associated with such a policy according to Figure 2.
There is a sort of faith that the economy will naturally return to the targeted steady state, since
that is the only long-run equilibrium outcome for the economy that is part of the analysis.
Stability
There is another version of the denial view that is somewhat less extreme but nevertheless
still a form of denial in the end. It is a view that I have been associated with in my own research.
In this view, one accepts the zero bound on nominal interest rates and the other details of the
analysis by Benhabib, Schmitt-Grohé, and Uribe. One accepts that there are two steady states.
However, the steady states have stability properties associated with them in a fully dynamic analysis, and the argument is that the targeted steady state is the stable one, while the unintended, low
nominal interest rate steady state is unstable. Therefore, according to this argument, one should
expect to observe the economy in the neighborhood of the targeted steady state and need not
worry about the unintended, low nominal interest rate steady state.
The original analysis by Benhabib, Schmitt-Grohé, and Uribe entailed much more than what
I have described in Figure 1. The figure outlines just the big picture. In fact, the authors wrote
down complete DSGE [dynamic stochastic general equilibrium] economies7 and analyzed the
dynamics of those systems in a series of papers. In the original analysis, the 2001 paper, they
endowed both the central bank and the private sector in the model with rational expectations.
They then showed that it was possible for the economy to begin in the neighborhood of the targeted steady state and follow an equilibrium path to the unintended, low nominal interest rate
steady state. These dynamics in fact spiraled out from the targeted steady state.
I did not find this story very compelling, for two reasons: because the dynamics described
seem unrealistic—they imply a volatile sequence of interest rates and inflation rates followed by
sudden arrival at the low nominal interest rate steady state—and because they rely heavily on
the foresight of the players in the economy concerning this volatile sequence.
A 2007 paper by Stefano Eusepi, now at the Federal Reserve Bank of New York, addressed
some of these concerns. Eusepi accepted the nonlinear nature of Figure 1 with its two steady
618
November/December 2013
Federal Reserve Bank of St. Louis REVIEW
Centennial Issue
states. He also backed off the rational expectations assumption that characterized the original
analysis by Benhabib, Schmitt-Grohé, and Uribe. Instead he assumed that the actors in the model
might learn over time in a specific way by considering the data produced by the economy itself.8
One key result in the Eusepi paper (2007) was the following: If the monetary authority, with
its nonlinear Taylor-type policy rule, reacts to inflation one period in the past (as perhaps one
might expect of many central banks), then the only possible long-run outcome for the economy
is the targeted steady state. I found this comforting. It suggests that one need not worry about
the unintended steady state and that exclusive focus on the targeted steady state is warranted.
To be sure, a careful reading of the Eusepi paper reveals that many other dynamic paths are also
possible, including some that converge to the unintended steady state. Still, one might hope that
the targeted steady state is somehow the stable one—and that for this reason one can sleep better
at night.
I’ve said this is a form of denial. First, as fascinating as they are, the results are not that clean,
as many dynamics are possible depending on the details of the model. It is hard to know how
these details truly map into actual economies. But more importantly, Figure 1 suggests that at
least one large economy has in fact converged to the unintended steady state. The stability argument cannot cope with this datum, unless one is willing to say that conditions are subtly different
in Japan compared with the United States, producing convergence to the unintended steady state
in Japan but convergence to the targeted steady state in the United States. I have not seen a compelling version of this argument. I conclude that the stability argument is actually a form of denial
in the end.9
The FOMC in 2003
In Figure 1, a set of data points is circled. These data are labeled “2003-2004” and are associated with a policy rate at 1.0 percent and the inflation rate between 1.0 and 1.5 percent. This
episode was the last time the FOMC worried about a possible bout of deflation. While core inflation did move to a low level during this period—not quite as low as the current level—inflation
moved higher later and interest rates were increased. This episode surely provides comfort for
those who think the Japanese-style outcome is unlikely. It suggests that the economy will ultimately return to the neighborhood of the targeted steady state, perhaps even indicating that the
stability story is the right one after all. The 2003 experience did not involve a near-zero policy
rate, however.
One description of this period is due to Daniel Thornton, an economist at the Federal
Reserve Bank of St. Louis.10 The Thornton analysis emphasizes (i) how the FOMC communicated during this period and (ii) how the market expectations of the longer-term inflation rate
responded to the communications. At the time, some measures of inflation were hovering close
to 1 percent, similar to the most recent readings for core inflation in 2010. At its May 2003 meeting, the Committee included the following press release language: “[T]he probability of an unwelcome substantial fall in inflation, though minor, exceeds that of a pickup in inflation from its
already low level.” At several subsequent 2003 meetings, the FOMC stated that “the risk of inflation becoming undesirably low is likely to be the predominant concern for the foreseeable future.”
By the beginning of 2004, inflation had picked up and FOMC references to undesirably low
Federal Reserve Bank of St. Louis REVIEW
November/December 2013
619
Bullard
Figure 3
Inflation Expectations, Interrupted
Nominal Interest Rate (percent)
5
Japan, Jan. 2002 to May 2010
U.S., Jan. 2002 to May 2010
4
Fisher Relation
(2.5, 3.0)
Nonlinear Taylor-Type Rule (π* = 1.75)
Nonlinear Taylor-Type Rule (π* = 2.5)
3
(1.75, 2.25)
2
2003-2004
1
(–0.5, 0.001)
May 2010
May 2010
–2.00
–1.50
–1.00
–0.50
0
0.00
0.50
1.00
1.50
2.00
2.50
3.00
Inflation (percent)
NOTE: The 2003-04 episode. Thornton (2006, 2007) argues that FOMC communications increased the perceived inflation
target of the Committee.
inflation ceased. Thornton shows that before any of these statements were made the longer-run
expected inflation rate, as measured from the 10-year Treasury inflation-indexed security spread,
was 1.74 percent during the period from January 2001 through April 2003. After the statements,
from January 2004 to May 2006, the longer-run inflation expectation averaged 2.5 percent.
Thornton interprets the FOMC language as putting a lower bound on the Committee’s implicit
inflation target range. This had the effect of increasing the longer-run expected rate of inflation.
Figure 3 shows how such a change in longer-run inflation expectations might play out.
Accepting the other premises of the analysis by Benhabib, Schmitt-Grohé, and Uribe, the private
sector now views the central bank as taking action to contain inflation only once inflation has
attained a somewhat higher level. Those in the private sector thought they understood policy as
the solid black line, but after the FOMC communication, they understood policy as the dashed
blue line. This alters the targeted steady-state inflation rate of the economy from 1.75 percent
(the second arrow from the right in Figure 3) to 2.5 percent (rightmost arrow).
It is not immediately obvious from Figure 3 why this should have a desirable impact on
whether the economy ultimately returns to the neighborhood of the targeted steady state or converges to the unintended, low nominal interest rate steady state. Credibly raising the inflation
target is actually moving the target steady-state equilibrium to the right in the diagram, farther
away from the circled data from 2003 and 2004. One might think that creating more distance
from the current position to the desired outcome would not be helpful.
620
November/December 2013
Federal Reserve Bank of St. Louis REVIEW
Centennial Issue
Figure 4
Discontinuity
Nominal Interest Rate (percent)
Japan, Jan. 2002 to May 2010
5
U.S., Jan. 2002 to May 2010
Fisher Relation
4
Nonlinear Taylor-Type Rule
(2.3, 2.8)
3
2
2003-2004
1
May 2010
May 2010
–2.00
–1.50
–1.00
–0.50
0
0.00
0.50
1.00
1.50
2.00
2.50
3.00
Inflation (percent)
NOTE: The discontinuous Taylor-type policy rule looks unusual but eliminates the unintended steady state.
In the event, all worked out well, at least with respect to avoiding the unintended steady
state.11 Inflation did pick up, the policy rate was increased, and the threat of a Japanese-style
deflationary outcome was forgotten, at least temporarily. Was this a brilliant maneuver, or did
the economic news simply support higher inflation expectations during this period?
Discontinuity
If the problem is the existence of a second, unintended steady state—and this is partly
caused by the choice of a policy rule that is controlled by policymakers—why not just choose a
different policy rule? This can, in fact, be done and was discussed by Benhabib, Schmitt-Grohé,
and Uribe in their original paper. Furthermore, some parts of the current policy discussion have
exactly this flavor.
The problem illustrated in Figure 1 is precisely that the two lines, one describing policy and
one describing private sector behavior, cross in two places. But the policy line can be altered by
policymakers. A simple version is illustrated in Figure 4. Here, the nonlinear Taylor-type policy
rule is followed so long as inflation remains above 50 basis points. For inflation lower than that
level, the policy rate is simply set to 1.5 percent and left there. This creates the black bar in
Figure 4 between an inflation rate of –1.0 percent (or lower) and 0.5 percent. The policy would
be that, for very low levels of inflation, the policy rate is set somewhat higher than zero, but still
Federal Reserve Bank of St. Louis REVIEW
November/December 2013
621
Bullard
at a very accommodative level. After all, short-term nominal interest rates at 1.5 percent would
still be considered aggressively easy policy in nearly all circumstances.
Of course, this policy looks unusual and perhaps few would advocate it, but again we are
trying to avoid all those circles down there in the southwest portion of the diagram. The discontinuous policy has the great advantage that it is a very simple way to ensure that the unintended,
low nominal interest rate steady state no longer exists. The only point in the diagram where the
Fisher relation and the policy rule can be in harmony is the targeted equilibrium. This would
remove the unintended steady state as a focal point for the economy.12,13
Some of the current policy discussion has included an approach of this type, although not
exactly in this context. The FOMC’s near-zero interest rate policy and the associated “extended
period” language have caused many to worry that the Committee is fostering the creation of
new, bubble-like phenomena in the economy that will eventually prove counterproductive. One
antidote to this worry may be to increase the policy rate somewhat, while still keeping the rate
at a historically low level, and then to pause at that level.14 That policy would have a similar flavor
to the one suggested in Figure 4, although for a different purpose.
Traditional Policy
According to the Bank of England,15 for 314 years the policy rate was never allowed to fall
below 2.0 percent. During more than three centuries the economy was subject to large shocks,
wars, financial crises, and the Great Depression—yet 2.0 percent was the policy rate floor until
very recently. A version of this policy is displayed in Figure 5. This policy rule does not eliminate the unintended steady state; it simply moves it to be associated with a higher level of inflation. In the figure, this point occurs at an interest rate of 2.0 percent and an inflation rate of 1.5
percent (the center arrow in the figure). This policy seems very reasonable in some ways. To the
extent that one of the main purposes of the interest rate policy is to keep inflation low and stable,
this policy creates two steady states, but the policymaker may be more or less indifferent between
the two outcomes. Then one has to worry much less about the possibility of becoming permanently trapped in an unintended, deflationary steady state. This policy prevents the onset of
interest rates that are “too low.”
The idea that policymakers might be more or less indifferent between the two steady states
brings up an important question about the original analysis by Benhabib, Schmitt-Grohé, and
Uribe. Why should one steady-state equilibrium be preferred over the other? This question has
some academic standing—there is a long literature on the optimal long-run rate of inflation,
and lower is usually better. In the conventional policy discussion, however, the targeted steady
state is definitely preferred. Perhaps the most important consideration is that, in the unintended
steady state, the policymaker loses all ability to respond to incoming shocks by adjusting interest
rates—ordinary stabilization policy is lost, possibly for quite a long time. In addition, the conventional wisdom is that Japan has suffered through a “lost decade” partially attributable to the
fact that the economy has been stuck in the deflationary, low nominal interest rate steady state
illustrated in Figure 1. To the extent that is true, the United States and Europe can hardly afford
to join Japan in the quagmire. Most of the arguments I know of concerning the low nominal
interest rate steady state center on the idea that deflation, even mild deflation, is undesirable. It
622
November/December 2013
Federal Reserve Bank of St. Louis REVIEW
Centennial Issue
Figure 5
Traditional Policy
Nominal Interest Rate (percent)
Japan, Jan. 2002 to May 2010
5
U.S., Jan. 2002 to May 2010
4
Fisher Relation
Nonlinear Taylor-Type Rule
(2.3, 2.8)
3
(1.5, 2.0)
2
2003-2004
1
May 2010
May 2010
–2.00
–1.50
–1.00
–0.50
0
0.00
0.50
1.00
1.50
2.00
2.50
3.00
Inflation (percent)
is widely perceived that problems in the U.S. financial system are at the core of the current crisis.
Given that many financial contracts (and, in particular, mortgages) are stated in nominal terms
and given that these contracts were written in the past (under the expectation of a stable inflation
around 2.0 percent), it is conceivable to think that deflation could hurt the financial system and
hamper U.S. growth.16
If we suppose that deflation is the main problem, then this could likely be avoided by simply
not adopting a rule that calls for very low—near-zero—interest rates. Instead, the rule could call
for rates to bottom out at a level somewhat higher than zero, as the traditional policy rule does.
Of course, a policy rule like the one depicted in Figure 5 does not allow as much policy accommodation in the face of shocks to the economy at the margin. But is it worth risking a “lost decade”
to get the extra bit of accommodation?
Fiscal Intervention Given the Situation in Europe
In the academic literature following the 2001 publication of the perils paper, some attempt
was made to provide policy advice on how to avoid the unintended steady state of Figure 1.17
This advice was given in the context of trying to preserve the desirable qualities of the Taylor-type
interest rate rule in the neighborhood of the targeted steady state. That is, even though interest
rate rules are the problem here, the advice is given in the context of those rules—as opposed to
simply abandoning them altogether.
The advice has a certain structure. It involves not changes in the way monetary policy is
implemented, but changes in the fiscal stance of the government. By itself, this makes the pracFederal Reserve Bank of St. Louis REVIEW
November/December 2013
623
Bullard
ticality of the solution much more questionable. But it gets worse. The proposal is for the government to embark on an aggressive fiscal expansion should the economy become enmeshed in a
low nominal interest rate equilibrium. The fiscal expansion has the property that total government liabilities—money plus government debt—grow at a sufficiently fast rate. Inside the model,
such a fiscal expansion eliminates the unintended steady state as an equilibrium outcome. By
this roundabout method, then, the only remaining longer-run outcome for the economy is to
remain in the neighborhood of the targeted steady state.
The described solution has the following flavor: The government threatens to behave unreasonably if the private sector holds expectations (such as expectations of very low inflation) that
the government does not desire. This threat, if it is credible, eliminates the undesirable equilibrium. Some authors have criticized this type of solution to problems with multiple equilibria as
“unsophisticated implementation.”18
Today, especially considering the ongoing European sovereign debt crisis, these proposed
solutions strike me as wildly at odds with the realities of the global economy. The proposal might
work in a model setting, but the practicalities of getting a government to essentially threaten
insolvency—and be believed—seem to rely far too heavily on the rational expectations of the
private sector.19 Furthermore, governments that attempt such a policy in reality are surely playing with fire. The history of economic performance for nations actually teetering on the brink
of insolvency is terrible. This does not seem like a good tool to use to combat the possibility of a
low nominal interest rate steady state.
Beyond these considerations, it is questionable at this point whether such a policy actually
works. Japan, our leading example in this story, has in fact embarked on an aggressive fiscal
expansion, and the debt-to-GDP ratio there is now approaching 200 percent. Still, there does
not appear to be any sign that their economy is about to leave the low nominal interest rate steady
state, and now policymakers are worried enough about the international reaction to their situation that fiscal retrenchment is being seriously debated.
Quantitative Easing
The quantitative easing policy undertaken by the FOMC in 2009 has generally been regarded
as successful in the sense that longer-term interest rates fell following the announcement and
implementation of the program.20 Similar assessments apply to the Bank of England’s quantitative easing policy. For the United Kingdom in particular, both expected inflation and actual inflation have remained higher to date, and for that reason the United Kingdom seems less threatened
by a deflationary trap. The U.K. quantitative easing program has a more state-contingent character than the U.S. program. The U.S. approach was to simply announce a large amount of purchases but not adjust the amounts or pace of purchases according to changing assessments of
macroeconomic prospects.
The quantitative easing program, to the extent it involves buying longer-dated government
debt, has often been described as “monetizing the debt.” This is widely considered to be inflationary, and so inflation expectations are sensitive to such purchases. In the United Kingdom, all
the purchases were of gilts (Treasury debt). In the United States, most of the purchases were of
agency—Fannie Mae and Freddie Mac—mortgage-backed securities, newly issued in 2009. It
624
November/December 2013
Federal Reserve Bank of St. Louis REVIEW
Centennial Issue
has been harder to judge the inflationary effects of these purchases, and so perhaps the effects
on inflation expectations and hence actual inflation have been somewhat less reliable in the
United States than in the United Kingdom.
The experience in the United Kingdom seems to suggest that appropriately state-contingent
purchases of Treasury securities are a good tool to use when inflation and inflation expectations
are “too low.” Not that one would want to overdo it, mind you, as such measures should only be
undertaken in an effort to move inflation closer to target. One very important consideration is
the extent to which such purchases are perceived by the private sector as temporary or permanent. We can double the monetary base one day and return to the previous level the next day,
and we should not expect such movements to have important implications for the price level in
the economy. Base money can be removed from the banking system as easily as it can be added,
so private sector expectations may remain unmoved by even large additions of base money to
the banking system.21 In the Japanese quantitative easing program, beginning in 2001, the BOJ
was unable to gain credibility for the idea that they were prepared to leave the balance sheet
expansion in place until policy objectives were met. And in the end, the BOJ in fact did withdraw
the program without having successfully pushed inflation and inflation expectations higher,
validating the private sector expectation. The United States and the United Kingdom have
enjoyed more success, perhaps because private sector actors are more enamored with the idea
that the FOMC and the U.K.’s Monetary Policy Committee will do “whatever it takes” to avoid
particularly unpleasant outcomes for the economy.
CONCLUSION
The global economy continues to recover from the very sharp recession of 2008 and 2009.
During this recovery, the U.S. economy is susceptible to negative shocks that may dampen
inflation expectations. This could push the economy into an unintended, low nominal interest
rate steady state. Escape from such an outcome is problematic. Of course, we can hope that we
do not encounter such shocks and that further recovery turns out to be robust—but hope is not
a strategy. The United States is closer to a Japanese-style outcome today than at any time in recent
history.
In part, this uncomfortably close circumstance is due to the interest rate policy now being
pursued by the FOMC. That policy is to keep the current policy rate close to zero, but in addition to promise to maintain the near-zero interest rate policy for an “extended period.” But it is
even more than that: The reaction to a negative shock in the current environment is to extend
the extended period even further, delaying the day of normalization of the policy rate farther
into the future. This certainly seems to be the implication from recent events. When the European
sovereign debt crisis rattled global financial markets during the spring of 2010, it was a negative
shock to the global economy and the private sector perception was certainly that this would delay
the date of U.S. policy rate normalization. One might think that is a more inflationary policy,
but TIPS [Treasury inflation-protected securities]-based measures of inflation expectations over
5 and 10 years fell about 50 basis points.
Federal Reserve Bank of St. Louis REVIEW
November/December 2013
625
Bullard
Promising to remain at zero for a long time is a double-edged sword. The policy is consistent
with the idea that inflation and inflation expectations should rise in response to the promise
and that this will eventually lead the economy back toward the targeted equilibrium of Figure 1.
But the policy is also consistent with the idea that inflation and inflation expectations will instead
fall and that the economy will settle in the neighborhood of the unintended steady state, as Japan
has in recent years.22
To avoid this outcome for the United States, policymakers can react differently to negative
shocks going forward. Under current policy in the United States, the reaction to a negative shock
is perceived to be a promise to stay low for longer, which may be counterproductive because it
may encourage a permanent, low nominal interest rate outcome. A better policy response to a
negative shock is to expand the quantitative easing program through the purchase of Treasury
securities. ■
NOTES
1
See Benhabib, Schmitt-Grohé, and Uribe (2001).
2
This is just for purposes of discussion—much of the formal analysis to which I refer later in the paper has stochastic
features that would allow the real rate to fluctuate over time. Generally speaking, short-term, real rates of return on
safe assets in the United States have been very low during the postwar era.
3
Steady states are considered focal points for the economy in macroeconomic theories—the economy “orbits” about
the steady state in response to shocks.
4
This example is meant as an illustration only. The formula I used to plot the nonlinear Taylor-type policy rule is
R = Ae Bπ, where R is the nominal interest rate, π is the inflation rate, and A and B are parameters. I set A = 0.005015
and B = 2.75. Taylor-type policy rules also have an output gap component, and in the literature that issue is discussed extensively. For the possibility of a second steady state, it is the inflation component that is of paramount
importance.
5
I discuss the social desirability of each of the two steady states briefly in the section titled “Traditional Policy.”
6
Over the years, some discussion in monetary theory has contemplated currency taxes as a means of obtaining negative nominal rates, but that is a radical proposal not often part of the negative rates discussion. See Mankiw (2009).
Interestingly, even negative rates would not avoid the multiple-equilibria problem—see, for instance, Schmitt-Grohé
and Uribe (2009).
7
That is, dynamic, stochastic, general equilibrium economies.
8
See Evans and Honkapohja (2001).
9
For an argument that, under learning, the targeted steady state is locally but not globally stable, see Evans, Guse,
and Honkapohja (2008). In their paper, the downside risk is much more severe, as under learning the economy can
fall into a deflationary spiral in which output contracts sharply.
10 See Thornton (2006, 2007).
11 Many have criticized the FOMC for allowing the target rate to remain too low for too long during this period. For a
discussion, see remarks by Fed Chairman Bernanke (2010) delivered at the annual meeting of the American
Economic Association.
12 The academic literature regarding the use of fiscal policy measures, as described below, has the same goal—unin-
tended outcomes are eliminated as equilibria. But the fiscal policy route is far more convoluted.
13 Two astute reviewers—Costas Azariadis and Jess Benhabib—both stressed that a discontinuous policy could create
a pseudo steady state (at the point of discontinuity) and that the economy might then oscillate about the pseudo
626
November/December 2013
Federal Reserve Bank of St. Louis REVIEW
Centennial Issue
steady state instead of converging to the targeted outcome. This has not been a subject of research in this context as
far as I know.
14 My colleague Thomas Hoenig (2010), president of the Federal Reserve Bank of Kansas City, has advocated such a pol-
icy. See his speech, “The High Cost of Exceptionally Low Rates.”
15 For historical data since 1694 on the official Bank of England policy rate, see
http://www.bankofengland.co.uk/statistics/rates/baserate.xls.
16 Some have argued that ongoing deflation in Japan is not an important contributory factor for the nation’s relatively
slow growth. See, for instance, Hayashi and Prescott (2002). In addition, the United States grew rapidly in the late
nineteenth century despite an ongoing deflation. So, the relationship between deflation and longer-run growth is
not as obvious as some make it seem. Still, the conventional wisdom is that a turn toward deflation would hamper
U.S. growth.
17 See, in particular, Benhabib, Schmitt-Grohé, and Uribe (2002), Woodford (2001, 2003), and Eggertsson and Woodford
(2003).
18 See Atkeson, Chari, and Kehoe (2010).
19 For a version that backs off the rational expectations assumption, but still eliminates the undesirable equilibrium,
see Evans, Guse, and Honkapohja (2008).
20 See, for instance, Neely (2010).
21 For discussions of how forms of quantitative easing can help achieve the intended steady state, in combination with
appropriate fiscal policy, see Eggertsson and Woodford (2003, pp. 194-98) and Evans and Honkapohja (2005).
22 Evans and Honkapohja (2010) have made a version of this argument more formally.
REFERENCES
Atkeson, Andrew; Chari, Varadarajan and Kehoe, Patrick. “Sophisticated Monetary Policies.” Quarterly Journal of
Economics, February 2010, 125(1), pp. 47-89.
Benhabib, Jess; Schmitt-Grohé, Stephanie and Uribe, Martín. “The Perils of Taylor Rules.” Journal of Economic Theory,
January 2001, 96(1-2), pp. 40-69.
Benhabib, Jess; Schmitt-Grohé, Stephanie and Uribe, Martín. “Avoiding Liquidity Traps.” Journal of Political Economy,
June 2002, 110(3), pp. 535-63.
Bernanke, Ben S. “Monetary Policy and the Housing Bubble.” Remarks before the Annual Meeting of the American
Economic Association, Atlanta, GA, January 3, 2010;
http://www.federalreserve.gov/newsevents/speech/bernanke20100103a.htm.
Eggertsson, Gauti and Woodford, Michael. “The Zero Bound on Interest Rates and Optimal Monetary Policy.” Brookings
Papers on Economic Activity, 2003, 1, pp. 139-211.
Eusepi, Stefano. “Learnability and Monetary Policy: A Global Perspective.” Journal of Monetary Economics, May 2007,
54(4), pp. 1115-131.
Evans, George; Guse, Eran and Honkapohja, Seppo. “Liquidity Traps, Learning, and Stagnation.” European Economic
Review, November 2008, 52(8), pp. 1438-463.
Evans, George and Honkapohja, Seppo. Learning and Expectations in Macroeconomics. Princeton, NJ: Princeton
University Press, 2001.
Evans, George and Honkapohja, Seppo. “Policy Interaction, Expectations and the Liquidity Trap.” Review of Economic
Dynamics, April 2005, 8(2), pp. 303-23.
Evans, George and Honkapohja, Seppo. “Expectations, Deflation Traps and Macroeconomic Policy,” in David Cobham,
Øyvind Eitrheim, Stefan Gerlach, and Jan F. Qvigstad, eds., Twenty Years of Inflation Targeting: Lessons Learned and
Future Prospects. Chap. 11. Cambridge, UK: Cambridge University Press, 2010, pp. 232-60.
Federal Reserve Bank of St. Louis REVIEW
November/December 2013
627
Bullard
Hayashi, Fumio and Prescott, Edward C. “The 1990s in Japan: A Lost Decade.” Review of Economic Dynamics, January
2002, 5(1): 206-35.
Hoenig, Thomas M. “The High Cost of Exceptionally Low Rates.” Remarks before the Bartlesville Federal Reserve
Forum, Bartlesville, OK, June 3, 2010; http://www.kcfed.org/speechbio/Hoenigpdf/Bartlesville.06.03.10.pdf.
Mankiw, N. Gregory. “It May Be Time for the Fed to Go Negative.” New York Times, April 18, 2009;
http://www.nytimes.com/2009/04/19/business/economy/19view.html.
Neely, Christopher J. “The Large Scale Asset Purchases Had Large International Effects.” Working Paper No. 2010-18A,
Federal Reserve Bank of St. Louis, July 2010.
Schmitt-Grohé, Stephanie and Uribe, Martín. “Liquidity Traps with Global Taylor Rules.” International Journal of
Economic Theory, 2009, 5(1), pp. 85-106.
Thornton, Daniel L. “The Fed’s Inflation Objective.” Federal Reserve Bank of St. Louis Monetary Trends, July 2006;
http://research.stlouisfed.org/publications/mt/20060701/cover.pdf.
Thornton, Daniel L. “The Lower and Upper Bounds of the Federal Open Market Committee’s Long-Run Inflation
Objective.” Federal Reserve Bank of St. Louis Review, May/June 2007, 89(3), pp. 183-93;
http://research.stlouisfed.org/publications/review/07/05/Thornton.pdf.
Woodford, Michael. “Fiscal Requirements for Price Stability.” Journal of Money, Credit, and Banking, August 2001, 33(3),
pp. 669-728.
Woodford, Michael. Interest and Prices: Foundations of a Theory of Monetary Policy. Princeton, NJ: Princeton University
Press, 2003.
628
November/December 2013
Federal Reserve Bank of St. Louis REVIEW
Challenging Policy
Throughout history, even intelligent and committed policymakers have disagreed and argued about the most
beneficial courses of action to pursue. The field of economics overall and monetary policymaking circles
specifically have had to contend with an often fragmented array of viewpoints. In the past and in recent years,
presidents of the St. Louis Fed have seen the challenging of conventional wisdom and practices as part of their
roles and responsibilities. In the two articles that follow, St. Louis Fed presidents, respectively, William Poole
and James Bullard, offer their perspectives on the policymaking response (or lack of response) to the government-sponsored enterprises (GSEs) and the financial crisis.
In the article “GSEs: Where Do We Stand?” former St. Louis Fed president Bill Poole summarizes his ongoing concerns about the role of the GSEs in promoting homeownership and in socializing the risk inherent in home
mortgages. He argues that the GSEs were undercapitalized and engaged in very risky lending that was subsidized by implicit government guarantees. In speeches made during the acceleration of the housing boom, Bill
Poole warned of the excessive risks being taken by the GSEs. Washington critics, at the GSEs and elsewhere,
argued that Poole was being naive, that he did not understand the sophisticated risk management practices
being used to hedge this risk. In retrospect, Poole was ahead of the curve and many of his policy recommendations are now under consideration as Congress struggles with GSE reform.
In our final article, “Seven Faces of ‘The Peril’,” St. Louis Fed president Jim Bullard reviews the body of research
that documents a fundamental problem facing policymakers when the policy interest rate is held at its zero
lower bound. The problem is simply that the profession does not have any widely accepted model of how the
economy and policy operate when money market (short-term) interest rates are held near zero. In theory, solutions can be found to particular models, but the solutions are so specific to the models that they cannot garner a consensus among policymakers. In practice, it is uncertain whether specific policies such as quantitative
easing and forward guidance will raise inflation, lower it, or have no effect at all. This article brings this issue full
circle to the warning raised by Beryl Sprinkel that it is very important for policymakers to be humble about the
models they use and to consider always what will happen if they are wrong.
@FedFRASER