Arnold Kling  

The Lost History of Volcker-era Monetary Policy

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Karl Smith writes,

Its as close to a test of modern macro theory as we have. We thought if we shrank the growth rate of the money supply we would get a recession but we also lower the rate of inflation. That's exactly what happened.

This is the bedtime-story of the Volcker era. However, it may not fit the facts. More below the fold.

I was an economist at the Fed at the time, starting in July of 1980. Paul Volcker had become Fed Chairman in August of 1979. As Carl E. Walsh's retrospective explains,

on October 6, 1979, the Federal Reserve adopted new policy procedures that led to skyrocketing interest rates and two back-to-back recessions but that also broke the back of inflation and ushered in the environment of low inflation and general economic stability the United States has enjoyed for nearly two decades.

Again, the bedtime story. But Walsh refers to a paper by David E. Lindsey, Athanasios Orphanides, and Robert H. Rasche (LOR) that is more nuanced.

LOR point out that at the time, prominent monetarists, such as Allan Meltzer, did not believe that the October 6 operating procedures would work. The monetarists pointed out that the new operating procedures did not really target money. Instead, the Fed set a target for "non-borrowed reserves." There was widespread suspicion that the Fed had not really abandoned its focus on the Federal Funds rate as its target. But it wanted more freedom to increase the target without calling attention to each increase as a policy move. "Non-borrowed reserves" acted as a kind of smokescreen, behind which these increases in interest rates could be hidden.

The Lindsey paper argues that the Taylor rule fit the pre-Volcker data as well as the post-Volcker data. They write,

the tendency of a standard forward-looking Taylor rule to predict a funds rate from early 1976 through mid-1979 that not only exhibited fairly subdued movements but also came reasonably close to the actual funds rate set by the FOMC...[this] highlights the fragility of supposedly efficient Taylor-rule prescriptions. The strategy of exact adherence to this rule would not have delivered much better outcomes than the policy in place before the reforms of October. And adherence after October 1979 would have prevented the tightening necessary for controlling inflation.

LOR point out that Chairman Volcker himself was extremely skeptical about the stability of the relationship between money growth and GDP, particularly in the short run.

Chairman Volcker. . . . I would remind you that nothing that has happened--or that I've observed recently--makes the money/GNP relationship any clearer or more stable than before. Having gone through all these redefinition problems, one recognizes how arbitrary some of this is. It depends on how you define [money].

LOR hasten to add that the Chairman was not a closet nominal-income targeter.

nominal income targeting would not have represented as stark a break from the gradualist policies of the past as the Committee must have felt was necessary. As described by Tobin, and in light of the policy lags involved, nominal income targeting would require the central bank to continue to fine-tune the stance of policy on the basis of predictions of the future, hardly a recipe for success given the profession's sad forecasting record earlier in the 1970s

What one comes away with is the impression that Chairman Volcker simply had a stronger preference for price stability (not just inflation stability) than just about any other prominent public official or economist, and he was very determined and very powerful in pursuit of his goals.

Some things that these retrospectives leave out that I remember.

1. The role of the Reagan tax cuts in prolonging the period of tight money. Many economists, both inside and outside the Fed, were convinced that the large increase in the deficit would unleash strong inflationary pressures. Interest rates were kept high in the hopes of neutralizing this inflationary surge. In fact, what ensued was unexpected weakness--either a single long recession or a double-dip, depending on how you want to look at it.

2. The role of the "bond market vigilantes." In a Sumnerian, rational-expectations world, the new operating procedures should have caused long-term interest rates to fall, as the markets anticipated lower inflation. In fact, bond markets seemed to be backward-looking with respect to long-term inflation expectations, and the higher short-term rates were simply added in to the expected long-term rate.

I think it is fair to say that high interest rates had something to do with the recession of the early 1980's, and the recession had something to do with the slowdown in inflation. That makes the 1980's contraction much more of a poster child for an aggregate demand story than for a recalculation story. But other issues are less clear.

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COMMENTS (10 to date)
Scott Sumner writes:

A couple comments on the Volcker era.

1. Volcker didn't consistently follow a contractionary policy. After an extremely brief recession in early 1980, the Fed panicked and eased sharply. By mid-1981 (i.e. after 2 years of Volcker) inflation was again at double digit levels. Fed anti-inflation policy had zero credibility, and for good reason.

Ratex doesn't mean perfect foresight. I concede that when the Fed again squeezed inflation in late 1981, expectations lagged behind reality for a while. But I recall that era; after two decades of steadily rising inflation nobody could imagine the oncoming Great Moderation. Almost everyone assumed that high inflation was something we'd just have to live with.

2. To test Ratex you really need a TIPS market. It was created in 1997 and the first big policy change was the unexpected easing of Jan 3, 2001. T-bill yields fell, stocks soared and long term nominal bond yields soared. Index bond yields rose modestly (expected income effect.) All four effects completely consistent with Ratex, and totally inconsistent with adaptive expectations.

A roughly similar pattern occurred with the easing of Sept 2007.

BTW, I agree that it doesn't fit the monetarist story all that well.

dWj writes:

Some guy named Ben Bernanke and his student Mihov did a paper around 1998 that strongly suggested, econometrically, that the Volcker fed really was targetting non-borrowed reserves rather than interest rates, at least in the short run. (It makes sense to me that perhaps Volcker viewed this as the politically possible way to tighten monetary policy, insofar -- if nothing else -- because the people who would complain about explicit high interest rates might not have an intuitive sense for what a given target for money growth would mean. In any case, though, the level of money growth that was set seems, in the short run, to really be what was being targeted.)

Josh writes:

The point about nominal income targeting is puzzling. First, it is obvious that there was no objective to target nominal income -- explicitly or implicitly. Second, and more importantly, the Fed did a better job forecasting nominal income than the output gap. (I have a paper on this where I look at the Fed's stance toward nominal income pre- and post-Volcker.)

Steve Sailer writes:

Scott Sumner said: "Almost everyone assumed that high inflation was something we'd just have to live with."

Yes, I specifically recall discussing with my cousins on December 25, 1982 how prices had fallen during the that Christmas shopping season, which surprised all of us after years of inflation. The following day, there was a huge turnout at the malls. And within a few months, with retail prices staying below expectations, it was clear that the big recession was over.

Jeff writes:

The monetarists favorite measure of money at that time had long been M2. It is worth remembering, however, that throughout the 1970's there did not seem to be a clear relationship between any of the aggregates and nominal income. Each of them had a velocity that did not appear stable enough to make for a good policy target. It was for this reason that the aggregates were redefined in 1980, with M2, in particular, defined so as to have a stable velocity over the preceding years. Knowing all of this, it is not surprising that Volcker, in effect, didn't trust any of the aggregates to give him a reliable signal.

andy writes:

Reading this made me think of one question: How often do central bankers screw up the economy?

In private sector you will easily find companies going bankrupt. When reading government regulations/expenditures, you could easily point to many being detrimental to the public good.

However - I have never seen anything like that being said by people believing in the 'aggregate demand story' about central banking. When you ignore Zimbabwe-like exceptions where it is too obvious, can you come up with some clear examples where the central bankers were wrong?

Greg Ransom writes:

I remember the surge of excitement the Reagan tax cut had on people.

People really believed America was back and the people had retaken the government.

Animal spirits were as high as I've ever seen them -- on the street for those who believed in the American system.

fundamentalist writes:

There are many, many factors to consider in the timing of the depression of the early 80's. Carter had begun deregulation of industries, especially oil, which would spur the supply side and help alleviate cpi inflation.

And as Kling has often mentioned, monetary pumping requires state spending to caise cpi inflation; without state spending monetary pumps cause asset inflation. This was Hayek's view as well. Yes, Reagan increased the deficit, but reducing the growth of total state spending would have reduced cpi inflation.

Ed Hanson writes:

Oh well, being a slow reader, I suspect I am asking questions on a topic that has gone stale, but here goes anyway.

1) The paper ended with the conclusion that Volcker was an original, after asserting that he was not a monetarist, any flavor of Keynesian, or other variety of major economic schools. But Paul Volcker is alive. Did the authors ever just ask him directly? Or did Volcker ever respond to the paper, or perhaps he still remains "Mystique"?

2) About the Taylor Rule. They assert that the authors' brand of the Taylor Rule is the same as John B. Is it? The authors also assert that the Taylor Rule is in good agreement with Fed FFR actions from 1976 through 1979, and after. Looking at the authors' Figure 6, the Taylor Rule and the actual FFR were far different then Taylor's criticism of the Fed from 2003 to 2005. Has John B. Taylor responded to this paper in particular or Orphanides in general?

Arnold? or anyone?

Ed Hanson writes:

Gee Whiz, I am really a slower reader that I thought, even reading my own posts. To make it clearer, the paper I am asking questions about was;

The Reform of October 1979: How It Happened and Why

David E. Lindsey, Athanasios Orphanides, and Robert H. Rasche

September 2004

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