Deficits to finance the Vietnam War spending and for the so-called Great Society increased the size of deficits. Chairman Martin often said that the Federal Reserve was independent within government. In practice, this meant that the Federal Reserve was free to raise interest rates enough to stop a private spending boom. But Congress approved government spending without increasing taxes, so the Federal Reserve was obligated to help finance the deficit. Martin’s beliefs about independence and policy coordination meant that money growth and inflation began to rise. Chairman Martin was strongly opposed to inflation, but his decisions started the Great Inflation. The Federal Reserve made the mistake of sacrificing its independence to coordinate. Many years passed before it restored independence. It learned that coordination worked only one way. The Federal Reserve supported administration actions, but there was no reciprocity.
4. Congress took a strong Keynesian approach in the report called Employment, Growth and Price Levels (Joint Economic Committee, 1960b, 6). The Federal Reserve demurred.
The simple Keynesian models used at the time encouraged the belief that economists could control short-term changes in such principal economic variables as economic growth, inflation, employment, and investment. This was hubris. The models at the time did not recognize anticipations and uncertainty, did not distinguish temporary and persistent changes, or distinguish real output and inflation, or real and nominal values of interest rates and exchange rates. As the text notes, some FOMC members pointed to these errors or omissions at times, but the comments did not influence either theory or policy.
Perhaps the two most costly errors in the 1960s were the sacrifice of Federal Reserve independence and reliance on belief that economists could improve welfare by trading a little more inflation for a lower unemployment rate. At his meetings with Presidents Kennedy and Johnson, Chairman Martin rarely made explicit commitments, but he was slow to raise interest rates despite recognizing the start of inflation after 1964.5 In 1968, he agreed that the administration’s tax surcharge would lower interest rates. He did not promise to lower them by Federal Reserve action, but he responded to pressure to do so. By year-end he acknowledged that he had made a mistake.
Early versions of the Phillips curve implied that increased inflation would permanently lower the unemployment rate. This was based on an error—failure to distinguish nominal and real responses. Friedman (1968b) pointed out the error; he explained that persistent inflation would increase expected inflation and restore equilibrium employment. Any reduction in unemployment would be temporary, but the increase in inflation would persist.
Policy actions in the 1960s were based on two mistaken beliefs that persisted until disinflation policy began in 1979–80. First was the claim that in a modern market economy like the United States, inflation started to increase before the economy reached full employment. The policy solution called for government intervention in the wage and price process to encourage non-inflationary settlements. In practice, the policy failed in the United States and abroad. It did not distinguish between price levels and rates of price change.
5. In 1962, he committed to keeping free reserves within a range. He did not tell the FOMC.
Second was dismissal of the role of money in monetary policy. For many years, the Federal Reserve gave most attention to money market conditions6 and to credit and interest rates. Later, it introduced a “proviso clause” that called on the manager to raise market rates if some measure of bank credit, reserves, or money grew faster or slower than a specified rate. The manager rarely acted on the proviso. The Board staff often explained the failures by claiming that the demand for money shifted. They never provided evidence, not even when challenged to do so. Another explanation was that responding to money growth required large changes and much greater variability of market rates. A solution adopted by the German Bundesbank and later the European Central Bank ignored short-term variations but responded to medium-term growth of a principal monetary variable.
Nelson (2003a, 1054) argues that money “serves as a proxy for a variety of yields that matter for aggregate demand.” As he notes, this is the implication of studies of the demand for money by Friedman, Schwartz, Brunner, and Meltzer. In periods when markets function well, short-term rates may summarize financial information. In periods when expectations are changing, other relative prices remain important.
Additional support comes from an exhaustive study of 1,000 demand functions for money. Knell and Stix (2004, 20) conclude in part, “In cases where a short rate is included with a long rate the short rate acts as an own rate (positive sign) for broad money but not for narrow money (negative sign). Concerning the size of the impact it is found that the sensitivity of money demand with respect to long rates is higher than with respect to short rates.”
A reason often given for neglecting money in policy analyses is that monetary velocity is highly variable. Chart 10.1 relates base velocity to a long-term interest rate. Two notable features of these data are: (1) when interest rates in the 1960s returned to the levels reached in the 1920s, velocity returned to those levels also; (2) during the disinflation of the 1980s, velocity and the interest rate declined along the path on which it rose during the peak years of the Great Inflation.
A possible third error mentioned in the text was the often stated idea that the Federal Reserve should create uncertainty. Rational expectations implies the opposite. It took time for the Federal Reserve to recognize that it depends on market responses, so it has a strong interest in informing markets about its policy and its intentions, beliefs, and interpretations. There are, of course, limits to what it can say because it is necessarily uncertain about the future. By letting the public know about the rule or quasi-rule that it follows, it permits the market to interpret incoming data more accurately.
6. In Chapter 4, I quote Stephen Axilrod, a principal staff member, expressing frustration about money market conditions. He noted that emphasis shifted from borrowing to free reserves, to color, tone, and feel, and other indicators. Money market conditions were often vague and loose and not closely related to inflation and growth.
Chapter 3 shows that several members of the FOMC, led by Sherman Maisel, recognized some of the principal problems with operating procedures in the 1960s. Members mentioned uncertainty, the problem of distinguishing permanent and temporary changes, and absence of agreement on how Federal Reserve actions should be judged and how they affected the economy. Vice Chairman Balderston at times commented on the absence of procedures to achieve long-term objectives. Chairman Martin showed little interest and made few changes.
The new Nixon administration in 1969 brought a different team of economists to give advice and, after a year, a new chairman of the Board of Governors. The new team accepted that excessive money growth was the principal cause of inflation and that the long-run Phillips curve was vertical. Higher inflation could not permanently reduce the unemployment rate.
The new Federal Reserve chairman, Arthur Burns, opposed administration efforts to influence Federal Reserve policy, but he did not hesitate to instruct the administration. He continued to give greater weight to reducing the unemployment rate than to reducing inflation. And he proposed repeatedly that the government adopt wage and price guidelines to keep prices from rising. After repeatedly opposing wage-price policy, President Nixon changed course, imposing price and wage controls in 1971. Later, he eased controls. The efforts, both more and less restrictive, failed. Reported inflation rose especially after controls ended.
Burns and other advocates never made a convincing argument showing why controls of prices would work to control rates of price change. One of their mistakes was to mix control of one or more relative prices with control of the sustained rate of price change. Suppose controls prevented a rise in steel prices. Unless the change somehow reduced total spending and increased saving, buyers would have more money to spend elsewhere. The lower relative price of steel might change a price index, but it would not change the (correctly measured) rate of
price change.
By suppressing the rise in the price level, controls encouraged the government to choose expansive policies to reduce unemployment. Unemployment was President Nixon’s main political concern, lest it deny him reelection. Controls were a political success; he was reelected. But inflation rose.
The Federal Reserve sacrificed much of its remaining independence to lower unemployment in time for the 1972 election. Burns met frequently with President Nixon, who urged him repeatedly to increase money growth. Burns agreed, but he could not do it alone. The other members of the Board had been appointed by Presidents Kennedy and Johnson. They had no reason to support President Nixon’s reelection. They acted on the belief that it was more important to reduce the unemployment rate than to control inflation. Like other members of the FOMC and principal members of Congress, they supported inflationary actions based on their beliefs about relative social costs. In some cases, FOMC members believed either that they would reduce inflation later or that inflation would not occur as long as price controls or slack remained. They were misled by their economic analysis and beliefs.
Failure to distinguish one-time price level changes from sustained rates of change became a more serious problem following oil price increases in 1973 and after. The Federal Reserve and many others did not separate the two reasons for higher prices. Both were taken as evidence of inflation. There was a difference, however. The one-time change in oil prices was a change in a relative price. Once it passed through the economy, the reported rate of price change would fall. If policy, especially monetary policy, remained unchanged, the reported rate of inflation would return to the rate preceding the oil price increase. The Federal Reserve’s actions and public statements would work to prevent the public from anticipating a persistent increase in the rate of price change.
Slowing money growth in response to the oil price increase reduced aggregate demand in the mistaken belief that lower aggregate demand could offset the effect of reduced aggregate supply. Since the first effect of reduced money growth is on output, the unemployment rate rose to the highest level since the 1937–38 depression. Predictably, the Federal Reserve responded to increased unemployment by increasing money growth, thereby converting some of the one-time price level change into persistent inflation.
This was an analytic error. The oil price increase reduced wealth. The wealth loss had to be borne by reductions in real wages and profits. By mistaking the wealth loss for a recession, the Federal Reserve postponed the loss and increased inflation
Economic theory does not give a firm answer to the question, Should the central bank stabilize the price level or the rate of price change? The former gives the public an opportunity to plan on stable prices, a valuable contribution to those planning investments and allocating wealth over time. This benefit carries a cost. It requires the central bank to reverse any increase or decline in the price level. The classical gold standard produced such a result. Over long periods, the price level remained approximately constant. The costs of achieving stable prices under the gold standard proved higher than the modern public is willing to bear. In democratic countries especially, the public expected the state to respond to unemployment. We do not have the gold standard not because we do not know about the gold standard; it is because we know about its costs.
Inflation control, unlike price level control, does not promise to keep the price level stable. The price level becomes a random walk around the constant (perhaps zero) average inflation rate. Positive oil shocks cause the reported price level to rise and negative oil shocks cause it to fall. Once the shocks pass through, the reported rate of inflation returns to its previous zero or perhaps 2 percent per annum. Currency devaluations or revaluations, excise tax changes, and changes in productivity similarly affect the price level but not the maintained rate of inflation. Sustained changes in the productivity growth rate would change the sustained rate of inflation unless money growth adjusted.
The Federal Reserve is in the money business. It is responsible for growth of the money stock and its consequences. By controlling money growth it influences growth of aggregate demand. It has no direct influence on aggregate supply, so it can respond to positive aggregate supply shocks only by introducing an unanticipated reduction in aggregate demand, reducing spending to lower prices. Such action complicates unnecessarily the consumer’s problem of determining expected future inflation and adds a monetary disturbance to the one-time reduction in measured output growth from the supply disturbance. Better to let the disturbance pass through. If government response is unavoidable, the supply shock should be seen as an increased tax paid to oil producers; offset it by lowering domestic tax rates.
The Federal Reserve treated the 1973 and 1979 supply shocks as inflationary. In 2006, they allowed the oil price increase to pass through and did not try to force other prices to offset it. They concentrated attention on preventing other prices from rising. This was a step forward. The Federal Reserve should complete the policy change by informing the public that they seek to control the maintained rate of price change, not the price level.
After 1979, “practical monetarism” replaced what remained of Keynesian analysis. In practice, practical monetarism suffered from three principal problems. First, monetarism is a medium- to long-term theory of inflation. Second, short-term money growth rates are relatively variable and difficult to forecast. Third, timing was poor. The Federal Reserve tried practical monetarism just at the time that Congress reduced financial regulation. This made it difficult to estimate how much money growth to permit. In 1982 the Federal Reserve gave up whatever remained of the policy of monetary control.
Paul Volcker recognized that monetary policy could not succeed based on quarterly or semiannual forecasts. At the policy discussion in December 1985 and elsewhere, he explicitly rejected short-term forecasts and fine tuning.7 In contrast, some FOMC members describe policy as “data driven,” suggesting that they change decisions based on noisy current data (Yellen, 2006, 3). That problem continues. Chairman Bernanke claimed that policy action should change only if new data change the outlook, and he has responded to noisy data in practice.
7. See Chapter 9 for the discussion and quotation. Stern and Feldman (2004, 2) reject the short-term focus that dominates policy decisions. “We conclude that current procedures put too much emphasis on short-term countercyclical policy and too little emphasis on longterm inflation control. We argue that these shortcomings could lead to significant monetary policy mistakes.” At the time this is written, May 2009, the FOMC has responded again to market and congressional pressures by giving main weight to recession and unemployment and little weight to longer-term inflation.
The staff continued to use a Phillips curve to forecast inflation. Research has shown that a key input to the forecast, the full employment level or natural rate of unemployment, has not been estimated accurately (Stock and Watson 1999). Orphanides and van Orden (2004) showed that main errors in forecasting inflation resulted from the use of contemporary data. These data differed substantially from the later revised data. Atkeson and Ohanian (2001, 10) concluded that “for the last 15 years, economists have not produced a version of the Phillips curve that makes more accurate inflation forecasts than those from a naïve model.” A principal reason is variability of the natural rate of unemployment or NAIRU.8
The text of Chapters 8 and 9 has many comments by Paul Volcker that praise the staff but dismiss their forecasts as inaccurate and unreliable. Alan Greenspan (2007, 170) also did not find staff inflation forecasts useful. “The ‘natural rate,’ while unambiguous in a model, and useful for historical analyses, has always proved elusive when estimated in real time. The number was continually revised and did not offer a stable platform for inflation forecasting or monetary policy.” I believe economists and central bankers should take seriously this rejection of Phillips curve forecasts by the two most successful chairmen of the Board of Governors.
Orphanides and van Orden (2004) compared al
ternative inflation forecasts using information available to policymakers at the time of the forecast. They found that using information about unemployment, as in the standard Phillips curve, was less accurate and less reliable than other models they studied.
Current academic researchers and many central bank staffs work within the analytic framework developed in Woodford (2003). Michael Woodford’s work is carefully and elegantly presented.9 It uses the rational expectations paradigm. Two equations determine output and inflation. The central bank sets the only interest rate in the model. All other rates and relative prices depend on the model and rational expectations.
The money stock, bank credit, and other financial variables have no independent role. Setting the interest rate determines the money stock from the demand function. Long-term interest rates depend only on current and expected future short rates. The model cannot analyze the financial failures that were a main concern in 2007.
8. Dennis (2007, 3) has surveyed recent Phillips curves and concluded that they were useful pedagogically but were not useful for practical policymaking. Arthur Okun (1980, 818), who relied on Phillips curve forecasts as a presidential adviser, described the work as “seriously undermined when that empirical generalization collapsed.”
9. The model builds on earlier work by Goodfriend and King (1997) andClarida, Gertler, and Gali (1999).
A central bank that used the Woodford model to set the interest rate would have to judge whether the policy was correct by observing output and inflation. These respond with a lag to interest rate changes so in practice central bankers rely on other measures, including money and credit growth, housing starts, industrial production, employment and unemployment, and many other variables, including anecdotal reports from their districts. They believe that these variables provide relevant, independent information.
A History of the Federal Reserve, Volume 2 Page 77