Volcker was a crisis manager whose immediate goal was to prevent a surge in inflation from permanently raising inflationary expectations. On October 9, 1979, Volcker (cited in Lindsey, Orphanides, and Rasche, 2005, 205) told the American Bankers Association that “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.” However, the road to restoring credibility for low inflation was long and difficult. The bond markets provided the most sensitive measure of inflationary expectations, and bond rates rose during economic recovery when real growth rose above trend.

At his first FOMC meeting as chairman, Volcker (Board of Governors Transcripts August 14, 1979, 21, cited in Goodfriend and King 2005, 27) explained the consequences of the loss of credibility: “I am impressed myself by an intangible: the degree to which inflationary psychology has really changed. … That's important to us because it does produce … paradoxical reactions to policy. … [T]he ordinary response one expects to easing actions … won't work if they're interpreted as inflationary; and much of the stimulus will come out in prices rather than activity.” Sensitivity to market expectations pushed the FOMC to raise the funds rate when the growth gap became positive not when a negative output gap approached zero. Bond market vigilantes pushed the FOMC to create a new monetary standard based on stable expected inflation as the nominal anchor.

Money targets had advertised the FOMC's commitment to lower inflation.

After 1983, high, variable inflation gave way to low, stable inflation while real output became less variable. Section I advances the “inflation-fighter” explanation of this result. Inflation arose in the 1970s because the FOMC responded only halfheartedly to inflation shocks. The subsequent decline in real variability arose from a decline in inflation shocks.

Section II advances the “inflation-creator” view, which emphasizes how discretion in the 1970s destroyed nominal expectational stability. Subsequent rule-like behavior restored it. The resulting discipline imposed on funds rate changes caused the yield curve to move in a way that replaced the alternation of periods of contractionary and expansionary monetary policy with a neutral policy that turned economic stabilization over to the price system (Hetzel 2006). An appendix argues that the Taylor Rule fails to offer a useful framework for understanding monetary policy.

The Fed as Inflation Fighter

The inflation-fighter view is in a traditional Keynesian spirit, which emphasizes a Phillips curve with inertia in inflationary expectations that exists independently of monetary policy. This inertia, reflected in expectations based on realized inflation, propagates inflation shocks. Consistent with the belief that the FOMC can predictably manipulate real variables, inflation arises when the central bank fails to raise the real interest rate and the unemployment rate sufficiently to offset such shocks.

Blinder and Reis (2005, 16) exposit this view:

The overview of stop–go in Chapters 23 and 24 identified monetary shocks with the monetary accelerations and decelerations associated with cyclical interest rate smoothing. Chapter 24 examined the timing relationships between these shocks and macroeconomic variables. This chapter uses a narrative overview to trace out the relationship between monetary disturbances, the real interest rate, and real output (hours worked).

A Narrative Overview

Starting in late 1968, the FOMC decided to lower inflation, which had risen from just over 1% in the years from 1960 through 1965 to 5% in the last half of 1968. It raised the funds rate and kept it at a cyclically high level even when weakness appeared in nominal output growth. M1 growth peaked in January 1969, growth in hours worked peaked six months later in July 1969, and the real rate peaked even later in July 1970 (row 3, Table 25.1). An empirical regularity is the lag in turning points in the real rate behind hours worked. In Table 25.1, column 7 shows the lag in turning points of hours worked behind M1, and column 8 shows the lag in turning points of the real rate behind hours worked.

In March 1971, the FOMC pushed the funds rate down to 3.5% (Figure 8.2). From February through June 1971, the real commercial paper rate averaged only .3% (Figure 8.3). M1 growth surged into low double-digits (Figure 8.2). Over the longer period from November 1965 through January 1971, the real interest rate had averaged 2.9%.

The twentieth century was marked by vast, horrific disasters as well as by widespread, beneficent progress. In the first half of the century, two world wars almost ended Western civilization. In the second half, democracy spread and living standards rose. Throughout, monetary instability interacted with social upheaval and political disorder. Inflation and deflation created feelings of powerlessness in the face of impersonal forces that promoted a search for scapegoats. Hyperinflation and depression contributed to the rise of Nazism in Germany. The stability of the deutsche mark then accompanied the German postwar growth miracle (Hetzel 2002a; 2002b).

In the United States, deflation and depression in the 1930s produced a decade of untold human misery. The Great Inflation of the 1970s spawned wage and price controls, which trampled on due process. The feeling of government's loss of control, symbolized by gas lines, helped propel Ronald Reagan into power. After Paul Volcker led the Fed to accept responsibility for inflation in 1979, an increase in monetary stability accompanied an increase in economic stability.

The success of the twenty-first century will depend upon how well societies learn the lessons of the twentieth century. The grand monetary experiment of the last century was the replacement of a gold standard with a fiat money standard. The failure of central banks to understand their new responsibility to provide a nominal anchor for prices lay at the heart of the spectacular monetary failures of that century.

On August 9, 1974, with the resignation of Richard Nixon, Gerald Ford became president. In the fall congressional elections, voters angered by Watergate elected an overwhelmingly liberal Democratic Congress. Republicans lost 48 seats in the House and 5 in the Senate. With the fall of Vietnam and, especially, Ford's pardon of Nixon, the Ford presidency became highly partisan.

The Republican administration and the Democratic Congress divided over economic policy. Democrats wanted to use government spending to lower the high unemployment created by recession and were tolerant of the then historically high government deficit. The administration, whose chief economist was Alan Greenspan, wanted to limit government spending to lower long-term structural deficits. It wanted to break a perceived link between government deficits, inflation, and boom–bust business cycles.

Administration Economic Policy

At its onset, the Ford administration attempted to reach out to Congress by responding to Senate majority leader Mike Mansfield's (D. MN) resolution requesting a conference on inflation. Addressing Congress just three days after being sworn in, Ford said that “inflation is domestic enemy number 1” (Porter 1980, 10). The administration intended to solicit opinions over how to deal with inflation and how to achieve cooperation between labor and management to defuse a perceived wage–price spiral. Ford presided at the September 27–28 conference, which he termed Whip-Inflation-Now (WIN). At the time, no one predicted the worsening of the recession. Real GDP had fallen in all of the first three quarters of 1974, but only moderately, and bipartisan concern existed over inflation.

Stop–go monetary policy began in Martin's final years as FOMC chairman. Why did he allow monetary policy to become inflationary?

The Spirit of Stop–Go Monetary Policy

In the 1960s, a demand for activist macroeconomic policy arose from a convergence of political imperative and intellectual consensus. An imperative for growth emerged out of the fiscal pressures created by the Vietnam War and the social divisions created by the war and the civil rights movement. President Johnson refused to choose between war expenditures and his Great Society programs. The economy had to grow flat-out to generate the revenues necessary to pay for guns and butter.

Riots in inner cities and the rhetoric of black militants polarized American society. The middle class watched in dismay as the pampered baby boom generation of students burned the American flag in street demonstrations. A political consensus arose on the need to maintain a rapidly growing economy and a low unemployment rate as a social balm for a deeply divided society. At the same time, a consensus existed within the economics profession that government should pursue an activist policy of aggregate demand management to assure steady growth and low unemployment. Keynesian economics promised to deliver the political imperatives of high growth and low unemployment.

With stop–go, policymakers pursued expansionary monetary policy when the unemployment rate was “high” under the assumption that aggregate-demand inflation could not arise with excess capacity in the economy.

The centralization of authority in national governments marked the twentieth century. In the realm of money, a fiat monetary standard run by national central banks replaced a commodity standard run largely impersonally. Only after repeated episodes of inflation and deflation did central banks realize their responsibility for the behavior of prices. The greatest episode of monetary instability was the Great Depression. As predicted by Adam Smith in the Wealth of Nations in the eighteenth century, the specialization of production allowed the creation of wealth in the nineteenth century. Economic specialization rests on two pillars: free trade and stable money. Stability of the purchasing power of money makes possible roundabout exchange instead of barter. In the Depression, governments and central banks brought down both these pillars.

The Gold Standard

In the heyday of the gold standard, the world had a dominant money market – London – and a preeminent central bank – the Bank of England. Britain viewed the gold standard as an extension of its imperial grandeur. A sine qua non for the international gold standard was the freedom to ship gold made possible by the absence of capital controls. That freedom of movement of capital made London the center of the world financial market, just as London was the center of the empire. No one could doubt the commitment of the Bank of England to maintaining the gold price of the pound.

The characterization here of policy in the final Greenspan years is that the FOMC pursued its basic expected inflation/growth gap procedures but raised its implicit inflation target from price stability to low inflation. If that characterization is correct, the issue arises of whether there is a conflict between the twin objectives of “price stability” and “maximum employment” legislated in the Federal Reserve Act. Does achievement of “maximum employment” require secular depreciation of the currency, albeit at a low level? Does positive inflation “buy” stability of real output?

Raising the Implicit Inflation Objective

After the Asia crisis, the FOMC replaced its implicit long-run objective for price stability with an objective of low inflation (Chapter 17). Henceforth, the FOMC demonstrated an aversion to inflation as low as 1%. Figure 20.1 shows inflation compensation inferred from the difference in nominal and TIPS yields for the five-year interval, five years in the future. It measures the market's expectation of trend CPI inflation. Markets expected near-price stability in fall 1998. Over 1999, expected trend CPI inflation rose to 2.5%. The FOMC conveyed no message that this level of expected inflation exceeded its desired level for actual inflation.

Over 2000, expected trend CPI inflation drifted down and at year end reached 1.75%. In 2001, policy followed the basic lean-against-the-wind pattern. In 2001 as the recession became evident, the FOMC lowered the funds rate in an amount commensurate with its past responses to weakness (Figure 21.5).

In 1995, the treasury led an IMF bailout of foreign investors in Mexico. The bailout set off a chain of destabilizing events. The amount of money potentially made available to prevent default by Mexico on dollar-denominated debt made banks willing to hold large amounts of short-term debt in U.S. allies. That debt made possible the Asia crisis. Banks made what looked like sure one-way bets in lending to Asian banks and then abandoned them en masse when currency devaluations caused insolvencies large enough to threaten the international safety net. The FOMC responded to the Asia crisis with expansionary monetary policy, which exacerbated an unsustainable rise in asset prices. The fall of lofty equity valuations created the 2000 recession.

The Mexico Bailout

By late 1994, the Mexican peso had become overvalued due to an unwillingness of the Mexican government to allow the exchange rate to depreciate sufficiently to compensate for domestic inflation. From 1990Q1 through 1994Q3, the Mexican CPI doubled. Over this same period, the U.S. price level rose by 18% and the peso price of the dollar rose by 30%. The combined rise of these last two variables, 48%, offset just less than half of the rise in the Mexican price level. By the end of 1994, U.S. goods looked 50% cheaper to Mexicans than they did at the beginning of the 1990s. Mexicans responded to the relative cheapening of U.S. goods by going on a shopping spree in the United States.

How did Mexico maintain an overvalued exchange rate?

What is the monetary standard? How does the Fed control inflation? Not only is there little consensus over answers to these questions, but there is also little consensus over how to organize the monetary experience of the twentieth century in a way that can discriminate between competing answers.

As a member of the Money and Banking Workshop at the University of Chicago, I had the privilege of listening to Robert Barro, Stanley Fischer, Robert Gordon, Robert Lucas, Bennett McCallum, Donald Patinkin, and, of course, Milton Friedman. I left Chicago for the Federal Reserve Bank of Richmond in 1975 with several assumptions about monetary economics: (1) the price level is a monetary phenomenon; (2) the price system works; and (3) the public learns to form its expectations in a way that conforms to the Fed's monetary policy (rational expectations).

Paul Volcker demonstrated that not only could the Fed control inflation, but that it could also do so without permanently high unemployment or periodic recourse to high unemployment. Conversely, low stable unemployment did not require monetary management through high, variable inflation. As a result, there is now considerable agreement over assumptions 1 and 2. The central bank, which possesses a monopoly over monetary base creation, controls trend inflation. As described by real business cycle models, the price system works well to offset shocks. However, economists still divide over the nature of inflationary expectations.

Is there inertia in inflationary expectations and in inflation independent of the systematic component of monetary policy?

From the mid 1960s through the end of the 1970s, low, stable unemployment became an objective of monetary policy. The resulting experiment in aggregate demand management produced what became known as stop–go monetary policy. The assumption that monetary policy could control the unemployment rate rested on a nonmonetary view of inflation. If real factors controlled inflation, the Fed could manipulate aggregate nominal demand to control unemployment.

Inflation at Full Employment

In the Kennedy administration, the conservatism of Treasury Secretary Douglas Dillon, Treasury Undersecretary Robert Roosa, and William McChesney Martin shaped policy. However, the activist Council of Economic Advisers chaired by Walter Heller shaped the intellectual climate. It wanted to make the 1946 Employment Act the organizing force behind economic policy. Although the act mandated “maximum employment” as a national goal, its general language robbed it of substance. As written, it was nothing more than a statement of good intentions.

The CEA made the Employment Act into a driving force for expansionary policy by assigning a number to full employment. “[A]n unemployment rate of about 4% is a reasonable and prudent full employment target for stabilization policy” (1962 Economic Report, 46). Henceforth, unemployment rates in excess of 4% generated public pressure for activist policies. Four percent unemployment became the banner for economic activism. Walter Heller (Hargrove and Morley 1984, 176) said later: “Putting … goals in quantitative terms was … terribly important. … [Q]uantitative goals … [got] the president committed to an expansionary economic policy.

The juxtaposition of the Great Depression and World War II raised expectations dramatically of what government stabilization policies could achieve. In 1932, the unemployment rate rose to 23.6%. In 1939, it was still 17.2%. In 1945, the last year of the war, the unemployment rate was 1.9%. The juxtaposition of massive unemployment in the Depression and full employment during World War II provided apparently incontrovertible evidence that government spending could provide a countercyclical stimulus to the economy. The Employment Act of 1946 gave the government responsibility for full employment. However, there appeared to be no place for monetary policy in the arsenal of government policies.

A changed Intellectual Environment

According to real bills, government could do nothing to arrest the painful economic adjustments that inevitably followed the collapse of a speculative mania. Depression had to run its course to eliminate excessive debt and to correct a maladjusted structure of wages and prices. The memoirs of Herbert Hoover (1952, 30) have forever associated this view with his Treasury Secretary Andrew Mellon, whom Hoover labeled a “leave it alone liquidationist”:

Macroeconomic miscalculations by policymakers cannot alone account for the decade and a half of high inflation following 1965. The desire of the political system to use inflation as a tax was a major factor. Friedman (1975, 149) explained: “From time immemorial, the major source of inflation has been the sovereign's attempt to acquire resources. … Inflation has been irresistibly attractive to sovereigns because it is a hidden tax that at first appears painless or even pleasant, and above all because it is a tax that can be imposed without specific legislation. It is truly taxation without representation.”

The political environment within which the Fed operated changed radically after the November 3, 1964, election. The election provided the mandate and the congressional votes to undertake a broad expansion of income redistribution programs. In the election, Democrats had campaigned for a national medical care program (Medicare) and a strong Social Security program. Republicans had campaigned for Social Security coverage limited to the needy elderly and financed out of general revenues. The elections gave the Democrats a 295–140 majority in the House and a net increase of 42 northern Democrats. The conservative coalition of Republicans and Southern Democrats that had blocked social legislation crumbled. In 1965, the Vietnam War defense buildup began. The political system demanded a rapidly growing economy that would generate continuous increases in revenue. For the Fed, that concern translated into pressure for “low” interest rates.

The Woodrow Wilson Presidential Library in Staunton, VA, contains an exhibit entitled “The Federal Reserve: Wilson's Enduring Legacy: A modern industrial nation must have a money supply that can expand and contract with the economic cycle.” There is a quotation from a 1913 address by Wilson to Congress: “We must have a currency, not rigid as now, but readily, elastically responsive to sound credit. … And the control of the system of banking must be public, not private, must be vested in the government itself” [italics added]. The aggregate demand management of stop–go imparted the same procyclical bias to money that had existed under the real bills doctrine. However, it did so with an inflationary bias.

Chapters 23–5 identify the empirical regularities that characterize the almost 20-year stop–go period following 1964. The Fed, not private markets, produced “inflation shocks.” Inflation is a monetary phenomenon in that high rates of money growth preceded increases in inflation. Contrary to Taylor (1999), the inertia in the interest rate that made monetary policy inflationary preceded inflation rather than followed it.

To use historical experience to decide between the competing hypotheses of Fed as inflation creator and inflation fighter (Chapter 22), one needs to understand how the monetary regime affects the predictive relationship between money and prices. In case 1, the central bank accepts responsibility for inflation, possesses credibility for its inflation target, and pursues a strategy consistent with achieving the target.

From mid 1997 through mid 1999, the FOMC departed from its standard procedures by not raising the funds rate in response to increases in resource utilization rates, particularly as measured by increased labor market tightness. Greenspan's conception of policy explains this departure. Greenspan viewed policy as a forecasting exercise based on reduced-form relationships for predicting inflation, especially between unit labor costs and prices. However, these relationships changed unpredictably over time. As a result, policy had to be discretionary. This discretion took the form of “risk management.” Especially, Greenspan believed that monetary policy should counter the irrational expectations of investors, as long as actual and forecasted inflation were benign. Expectations were always central, but because they are not disciplined by a monetary policy rule, policy is necessarily discretionary.

In Measuring Business Cycles, Burns and Mitchell (1946) pioneered the atheoretical approach to forecasting used by business economists. They searched over the business cycle for empirical regularities, which they used to classify economic indicators as leading, contemporaneous, and lagging. Greenspan came out of this school. For him, monetary policy involved using empirically derived forecasting relationships in a way that allowed the FOMC's response to change when those forecasting relationships changed.

Greenspan (June 15, 2004, 11) wrote: “Policymakers have needed to reach beyond models to broader – though less mathematically precise – hypotheses about how the world works.” Greenspan (March 1997, 196) summarized his views: