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Thursday, June 23, 2005

Did Monetary Policy Change Permanently in 1979?

[Note: This is a nice non-technical discussion of monetary policy, but the post is somewhat long. If you are more interested in Social Security and other issues, scroll right on by ...]

There has been quite a bit of discussion concerning the merits, implementation, and effectiveness of inflation targeting lately at this site. I’ve been watching for something readable but still technically sound on this topic to pass along and I recalled this piece by Benjamin Friedman, first presented at the Federal Reserve Bank of St. Louis conference on “Reflections on Monetary Policy 25 Years After October 1979,” St. Louis, October 7-8, 2004. Before discussing the paper, let me point those of you who are advocates of inflation targeting and those of you who have reservations about inflation targeting to two readable papers on this issue:

  • Friedman, Benjamin M. 2004. "Why the Federal Reserve Should Not Adopt Inflation Targeting." International Finance, 7 (March), 129-136. [copy here]   
  • Mishkin, Frederic S. 2004. "Why the Fed Should Adopt Inflation Targeting." International Finance, 7 (March), 117-127. [copy here]   

The question Friedman is addressing in this paper is how policy to today is related, if at all, to changes in monetary policy implemented during the Volcker years in response to the October 1979 experience. There are three areas of focus, a change in policy objectives such as placing more weight on inflation and less on output, a change in the policy instrument such as a change from an interest rate target to targeting a monetary aggregate, and a change in focus from monetary aggregates such as M1 and M2 to measures of reserves or the monetary base. The paper also talks about why the Fed might be too hesitant to adjust interest rates in response to economic conditions as reflected in measures such as inflation and unemployment, another recent topic of discussion, and how this results in a lagged interest rate term in the Taylor rule (this is called smoothing). Finally, commitment to rules versus discretion in monetary policy is also discussed. For those who are interested in this topic, I think this is worth reading:

What Remains from the Volcker Experiment?, Benjamin M. Friedman, NBER Working Paper No. 11346, May 2005 (sub.): [also available free here]:… [T]here remains a widespread sense that the world of monetary policymaking in the United States has been somehow different since 1979. What exactly is different, and in what respects those differences stem from the innovations introduced in 1979, are questions well worth addressing. … [T]he broad public discussion of the Federal Reserve’s new approach in 1979 primarily emphasized the elevation of quantitative money growth targets … from the irregular and mostly peripheral role … to center stage. ... The Open Market Committee had chosen to place primary emphasis on the narrow M1 aggregate, but … Evidence since then shows that by the mid 1980s M1 had disappeared altogether as an observable influence on policymaking, and the same happened to the broader M2 measure by the early 1990s … [T]he main point here is simply that the reliance on money growth targets that was key to at least the public presentation of the new monetary policy regime in 1979 has now entirely disappeared.

The same is true for … an open market operating procedure based on the quantity of either nonborrowed or borrowed reserves. … The only way in which some version of a reserves-based operating procedure could have survived … would have been if policymakers thought the relationship between reserves growth and economic activity was more reliable than the relationship between interest rate growth and economic activity. Few economists have been prepared to make that case. As a result, the Federal Reserve has gone back to carrying out monetary policy by fixing a short-term interest rate – in the modern context the overnight federal funds rate – just as it did for decades prior to 1979.

That leaves … the Volcker experiment represent[ing] a new, presumably greater weighting attached to achieving “price stability” … has that greater weighting survived? The post-1979 record of price inflation in the United States surely creates some prima facie presumption to this effect. … Does this … represent a genuine change in the weighting placed on inflation … Or is there some other explanation, independent of the Volcker experiment? One point worth making explicitly is that … there is no evidence that the increased tolerance for interest rate fluctuations that the Federal Reserve exhibited during the Volcker period has survived. One of the most frequently offered criticisms of monetary policy operating procedures based on fixing short-term nominal interest rates is that central banks have traditionally proved too hesitant to adjust the interest rates they set, and when they do move interest rates they have tended to do so too slowly. The usual explanation is that, in addition to their objectives for such macroeconomic variables as price inflation and the growth of output and employment, central banks also take seriously their responsibility to maintain stable and well functioning financial markets … For this reason, now-conventional expressions of operating rules for monetary policy, like the “Taylor rule,” normally include a lagged interest rate along with measures of inflation and output (or employment) relative to the desired benchmark.

Part of what distinguished the Volcker experiment was the unusually wide … fluctuations of short-term interest rates that occurred under the Federal Reserve’s quantity-based operating procedures. … in recent … no such fluctuations have been allowed to occur. Might the Federal Reserve again permit them if doing so seemed necessary to rein in incipient inflation? Perhaps so, but on the evidence there is no ground for claiming that this aspect of the 1979 experiment has survived either. …

The United States experienced little inflation in the 1950s, and not much in the 1960s either. Hence the historical evidence is also consistent with the view that the 1970s were exceptional, rather than that the experience since 1979 has differed from what went before as a whole. Even the idea that the Volcker experiment represented a return to the greater policy weight on price stability vis-a-vis real outcomes that had motivated the Federal Reserve before the 1970s, and that this renewed commitment to price stability has lasted ever since, would make the events of 1979 a major and lasting contribution to U.S. monetary policymaking. But … other explanations are also possible. … Resolving the merits of … other potential interpretations of the historical record … is surely a worthwhile object of empirical research. … Finally, one further aspect of what 1979 may or may not have been about bears attention. Perhaps what was important about the changes … was not the specifics of money growth targets and reserves-based operating procedures but rather … in the traditional language of this subject, to impose “rules” where there had been “discretion.” … But to the extent that it was a form of rule … it too clearly failed to survive. Federal Reserve policymaking in recent years has epitomized what “discretion” in monetary policy has always been about. Precisely for this reason, advocates of rules over discretion today continue to seek some way of moving Federal Reserve policymaking in that direction. The proposal of this kind that has attracted the most interest currently is “inflation targeting.” Whether adopting inflation targeting would be a good or bad step for U.S. monetary policy is a separate issue. But one reason the issue is even on the agenda today is that the movement in this direction that the experiment of October 1979 represented did not last either.

    Posted by on Thursday, June 23, 2005 at 02:34 AM in Academic Papers, Economics, Monetary Policy, Reading | Permalink  TrackBack (0)  Comments (2)

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