The U.S. Monetary Experience of 1979-1982

This is something I want to have available here for reference, but if anyone is interested in it, so much the better. It is Bennett McCallum's account of the 1979-1982 period in monetary history from his book Monetary Economics: Theory and Policy:

1.3 The U.S. Monetary Experience of 1979-1982

Having briefly highlighted some contrasts between the pre- and post- World War II record, let us now consider a recent episode that has received considerable attention. As a result of the relatively severe inflation of the late 1970s, Volcker and other officers of the Fed became convinced during 1979 that to prevent an extremely unhealthy situation they would need to exercise tighter control over growth of the money stock than in previous years. To facilitate such control,[10] they publicly adopted on October 6, 1979, a new set of operating procedures, procedures that featured increased emphasis on a particular measure of bank reserves (i.e., nonborrowed reserves) and reduced emphasis on short-term interest rates. Their new procedures were supposed to be helpful to the Fed in achieving its targets for money supply growth-targets that it had been announcing since 1975 but failing to achieve in most years.

The practice of announcing these money supply targets, it should be explained, had been reluctantly adopted by the Fed at the insistence of the U.S. Congress.[11] As can be seen from Table 1-3, the targets were not highly precise. For the year ending with the fourth quarter of 1978, for example, the target consisted of a range of values for the money growth rate that extended from 4.0 to 6.5 percent. (The actual value turned out to be 7.2 percent in this year, as can also be seen from Table 1-3.) Given the modest degree of precision sought for, it appeared that the failure to achieve the official targets should in principle be correctible.

The new operating procedures begun in October 1979 were kept in place by the Fed until late 1982, with September 1982 usually regarded as the last month of the episode. Because so-called "monetarist" economists had for many years been recommending tighter money stock control as the best way of fighting inflation, and had often recommended operating procedures with a measure of bank reserves[12] as the key variable, this experience has frequently been termed a "monetarist experiment." Actually, for various reasons, that label is highly inappropriate.[13] But the episode did nevertheless constitute a policy experiment of a sort, and is therefore of considerable interest.

What, then, were the results of this experiment? In one respect the Fed's attempts were successful: by September 1982 the U.S. inflation rate had been reduced from around 11 or 12 percent (per year) to a magnitude in the vicinity of 4 or 5 percent. Other aspects of the outcome were not as planned, however, and were highly unpopular with the public and with most commentators. Of these undesirable side effects, four will be mentioned. First, short-term interest rates rose to levels unprecedented in U.S. history. Over the month of May 1981, for example, the 90-day Treasury bill rate averaged 16.3 percent. Second, the extent of month-to-month variability of interest rates was greater than ever before. Third, in 1981 a recession began that was the most severe since the Great Depression of the 1930s; the nation's overall unemployment rate climbed over 10 percent in the second half of 1982. So while the economy was relieved -- at least temporarily -- of the inflationary pressures that it had been experiencing for about a decade, this relief was apparently[14] obtained at the cost of an unwelcome recession and the associated loss in output.

Perhaps the most interesting aspect of the episode, however, pertains to the fourth item on our list: the Fed did not succeed in improving its record of money stock control. Instead, the realized growth rates for the years ending in the fourth quarter of 1980, 1981, and 1982 were again outside the specified target range, as indicated in Table 1-3. And monthly values of the growth rate were highly variable, as can readily be seen from Figure 1-1. This is especially striking, of course, because the special operating procedures of 1979-1982 were designed precisely for the purpose of improving money stock control so as better to achieve the monetary growth targets!

The facts that we have just reported are not a matter of dispute - students of the episode agree that inflation came down, unemployment rose, interest rates became high and variable, and money stock targets were not met. What interpretation to place on the facts is, however, another matter. To some economists they suggest that it is unwise to pursue money stock targets, in part because of the putative unreliability of money demand behavior in an economy in which new payments practices and financial assets are constantly being developed.[15] To other economists, however, the experience illustrates how poorly the Fed's procedures were designed for money stock control, and how dangerous it is to allow excessive money growth -- and the inflation that it engenders -- to become established in an economy.[16]

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[10] According, at least, to the Fed's public statements on the subject.

[11] On this topic, see Weintraub (1978).

[12] Total reserves, however, not the nonborrowed reserves measure actually emphasized by the Fed.

[13] In particular, monetarist prescriptions have typically stressed the importance of nearly constant money growth rates and the absence of activist attempts to vary these rates countercyclically. In fact, the Fed did not abstain from activism during 1979-1982 and - as we will see shortly - money growth rates were far from constant. For an elaboration on this argument, see Friedman (1983).

[14] The word apparently is inserted because a few economists would argue that the recession of 1982-1983 was not brought about by the monetary policy under discussion. The viewpoint of such economists is discussed in section 9.7.

[15] For an expression of this view, see Blinder (1981) or Bryant (1983).

[16] These views are expressed by Brunner and Meltzer (1983) and Friedman (1983), among others.