Reflections on Monetary Policy 25 Years After October 1979

Federal Reserve Bank of St. Louis Review
March/April 2005
Vol. 87, No. 2, Pt. 2
www.stlouisfed.org

On Oct. 6, 1979, the Federal Open Market Committee—under the leadership of Paul Volcker—made a decision that would come to be known as a key moment in U.S. economic policymaking, a turning point in the history of the Federal Reserve that would forever alter central banking. And those are the understatements.

A defining moment may shape the direction of an institution for decades to come. In the modern history of the Federal Reserve, the action it took on October 6, 1979, stands out as such a milestone and arguably as a turning point in our nation's economic history.

That's according to Volcker's successor, Fed Chairman Alan Greenspan, and he is not alone in that view.

So, what did the FOMC do? It made a short-term change in the method used to conduct monetary policy, from making adjustments in the federal funds rate to containing growth in the monetary aggregates. (Yes, the Fed now targets the funds rate again—the 1979 change was reversed in 1982—but more on that in a minute.) This meant the Fed would focus on controlling the amount of reserves provided to the banking system, which would ultimately limit the supply of money.

Sounds pretty arcane, right, so what's the big deal? The big deal is this: By changing the way it conducted monetary policy, the Fed was saying that it was willing to commit to a then-radical method of managing the nation's money supply and that it would finally slay the inflation dragon that was stalking the land. The key word in that sentence is "commit." What the Fed had to do was not only kill the inflation dragon, but convince businesses and consumers that the dragon was really dead and that it would never come back to terrorize them. Inflation was one thing, but an expectation of escalating inflation—when inflation rates were already double-digit—was quite another, and much more debilitating to an economy.

A review of contemporary records (or, for some of us, a scan of our own memories) reveals how insidious inflation had become. Young readers who know only a post-Volcker world will probably have trouble imagining a time when U.S. policymakers were so vexed by inflation that they established wage and price controls in a vain attempt to keep rising prices at bay. But that's exactly what happened under the Nixon administration. These days, even Macro 101 students learn to snicker at such naiveté.

But that was then. And the 1970s were, indeed, a dark time for U.S. monetary policymaking. The period has even been given a capitalized moniker—the Great Inflation. While not nearly as famous (or infamous) as an earlier capitalized era, the Great Depression, the Great Inflation may go down in economic history as an equally important period of study.

Credibility, thy name is Paul

Six days after the Oct. 6, 1979, FOMC announcement, a story appeared in the Wall Street Journal that included the following:

Among those who are skeptical that the Fed will really stick to an aggregate target is Alan Greenspan, president of Townsend-Greenspan & Co., a New York economics consultant. Mr. Greenspan, who served as chief economic adviser to Presidents Nixon and Ford, questions whether, if unemployment begins to climb significantly, monetary authorities will have the fortitude to "stick to the new policy."

There it is again, the credibility to commit, from a man who would later become an icon of credibility and whose imminent departure as Fed chairman has set tongues wagging and nerves on edge. Why are some people anxious about the prospect of a new Fed chairman, and why were presidents reluctant to replace Greenspan until, by law, he had to leave? Not because there aren't a lot of good economists who are perfectly able to understand the complexities and nuances of monetary policy. If that were the only prerequisite for a Fed chairman, we could just check academic credentials or, for that matter, give each candidate a test. But how do we test for "fortitude"? Maybe we can't. How do we test for credibility? Maybe it must be earned.

The same holds true for institutions. Much of the goodwill that the Federal Reserve System has acquired over the last 25-plus years redounds from the authority, commitment and, ultimately, success of the person at the helm. This takes nothing away from the FOMC and the many other dedicated professionals at work within the Federal Reserve System—we all know that a bulwark of our central bank is its regionalized and independent structure that allows for opinion-sharing and ensures consensus-building. And this system works.

Additionally, there is much to be said for institutional memory and the accrued wisdom of the last two and a half decades, which suggest that the Federal Reserve would never repeat the mistakes of old because it has learned its lessons well. This argument holds that the Federal Reserve, as an institution, has learned the lessons of inflation-fighting and has earned enough credibility over the preceding 25 years to render the chairmanship, in effect, less meaningful.

Maybe so, but in the meantime, a review of the Volcker era points to the importance of leadership in guiding this decentralized central bank along a path of committed policy, and we are lucky to have a timely compilation of analysis, critique and reminiscence produced recently by the St. Louis Fed. Last year, on the occasion of the 25th anniversary of that momentous October day, the St. Louis Fed held a conference that gathered the leading lights on monetary policy, from economists to policymakers themselves, to review and reassess the Great Inflation. This past spring, the Bank dedicated a special volume of its quarterly Review to the conference proceedings.

The St. Louis Fed deserves kudos for holding the conference, but also for producing this useful resource on the subject. This particular issue deserves a wider audience than a typical academic journal, and that's why we're taking the rather unusual step of including it in our book review section. This Review, which includes not only papers and commentaries by economist and Fed historian Allan Meltzer, economist Christina Romer, former Undersecretary of the Treasury John Taylor, Richmond Fed economist Marvin Goodfriend and former Board official Stephen Axilrod, but also remarks and discussion from Alan Greenspan, former Fed Governors Ben Bernanke and Alan Blinder, current Vice Chairman Roger Ferguson and William Poole, the St. Louis Fed president, among many others.

In addition, the Review's editors gathered reflections from a wide variety of contributors, from economists to international policymakers to former Fed officials, including—in a touch of editorial enlightenment—Joseph Coyne, the longtime assistant to the Board who managed media relations. Coyne is well known to a generation of Fed reporters, and his stories not only bring a human element to the events of the day, but they are also exactly the kind of "color" that a Fed media representative would not have shared with reporters at that time.

One of the core papers in the Review is "The Reform of October 1979: How It Happened and Why," by David E. Lindsey, deputy director of the Federal Reserve Board's Division of Monetary Affairs (until his retirement in 2003); Athanasios Orphanides, adviser in the Board's Division of Monetary Affairs and a research fellow for two think tanks; and Robert H. Rasche, director of Research at the St. Louis Fed. Lindsey, Orphanides and Rasche (LOR) make good use of documents from that era—from newspaper clips to FOMC transcripts—to tell their sometimes dramatic story.

OK, so maybe you have to be something of a policy geek to use the term "dramatic" to describe a paper with 12 mini graphs on one page that depict the evolution of Greenbook forecasts during 1979. But trust me: The story LOR tell, with liberal quotations from FOMC transcripts, is more than a serious piece of economic research; it's pretty good narrative history. Take these samples of LOR's text:

• "The events of September 18 had a swift destabilizing effect on markets. ... Commodity markets, in particular, became extremely volatile, alarming policymakers."

• "The behavior of prices in these markets changed dramatically ... intraday volatility increased substantially."

• "As September drew to a close, the crisis that Chairman Volcker spoke of at the August FOMC meeting evidently had arrived."

• "Chairman Volcker arrived in Washington on Tuesday, October 2, his ears still resonating with strongly stated European recommendations for stern action."

• "The special meeting, scheduled in secret and on very short notice, was to take place on October 6, in Washington."

LOR may wince a bit to have their paper reviewed on its storytelling merits, but the point is that their paper—as well as the whole Review—is useful to readers of all levels. Of course, the authors not only tell us what happened, but they give their views as to why, as their title suggests, and here is where they sharpen their analytical pencils. LOR list 12 reasons the FOMC acted as it did, and then they dissect each at appropriate length. For brevity's sake, those dozen sections can be squeezed down to the following summary points: Inflation was so well entrenched in the United States that the FOMC was required to do something to restore the public's faith and contain "inflationary psychology." The FOMC's action had to sharply break from previous practice, it had to be transparent, and it had to allow for the possibility of high short-term interest rates. Finally, the FOMC had to convince financial markets and the public that it would succeed, thereby making its action politically acceptable.

As a side note: LOR address the long-held notion that the Fed's shift in policymaking was a move toward monetarism. This may have been true in deed, but not in intent, according to the authors:

The available record does not suggest that the FOMC was converted to monetarist ideology. The "monetarist experiment" of October 1979 was not really monetarist! Rather, the new techniques were conditionally adopted for pragmatic reasons.

And who was the author of this dramatic pragmatism? Chairman Volcker, of course, and if LOR's discussant had one bone to pick with their paper, it is that the authors did not give enough credit to the man with the cigar. Stephen Axilrod, a key player in the events of the time as the Board's staff director for Monetary and Financial Policy, had this (and more) to say about Volcker's contribution:

I believe the events of October 1979 represent one of the few instances in monetary history when a significant policy change—a change that was essentially a paradigm shift—would not have occurred except for the presence and influence of one individual.

Axilrod says Volcker employed two characteristics not commonly found in leaders: He was an artistic policymaker, inasmuch as he could think outside the proverbial box, and he was a master of the arcana of monetary operations, so much so that he inspired great trust among his colleagues. According to Axilrod, those traits gave Volcker the personal confidence—"and perhaps more importantly, the aura"—to convince not only his colleagues but also the public that the Fed was right to act boldly, and that it was committed to its actions.

If credibility is difficult to test for in a prospective Fed chairman, then aura must be nearly impossible. But it's a trait that has also been attached to Greenspan. For example, a recent art show in the Hamptons, on Long Island, consisted of nothing but painted portraits of Alan Greenspan, all of which sold within a few days at prices ranging from $1,000 to $4,000, many to Wall Street-types, according to a report on Central Banking Publications' Web site. "For some people, the mere image of Greenspan is pleasing," the report says. (Now that's aura.)

Other core papers in the Review include "Origins of the Great Inflation," by Allan Meltzer, which may well be a preview of a forthcoming chapter in volume 2 of his Federal Reserve history; "The Monetary Policy Debate Since October 1979: Lessons for Theory and Practice," by Marvin Goodfriend, which is a useful review of how economists reacted to the Great Inflation and what impact their ideas had on policy; and "The International Implications of October 1979: Toward a Long Boom on a Global Scale," by John Taylor, which reminds us that the United States was not the only country experiencing problems with inflation in the 1970s and describes the impact of the Fed's new policy on other countries. Space does not allow a review of all these works and their discussants' comments, but all deserve close reading.

From credibility to the "clash"

There is much richness between the staid covers of this Review. In his remarks as part of a panel discussion, Ben Bernanke examines the academic contributions of those who helped establish and explain the importance of credibility in policymaking (including Finn Kydland and Ed Prescott, 2004 Nobel Prize winners), and then he takes up a question that is particularly germane to current events—and, as it turns out, his own career: How to pick a good central bank chairman.

Here, Bernanke cites the work of Ken Rogoff, then a Fed Board economist and currently a Harvard professor, who suggests that a president needs to appoint an independent inflation hawk. This makes sense even if the president doesn't particularly care about inflation or is more concerned about economic performance in the short run and is therefore less averse to an increase in prices. Why should such a president select an inflation hawk? Because, as Bernanke explains:

As increased credibility allows the central bank to achieve low inflation at a smaller cost than a noncredible central bank can, the President may well find, somewhat paradoxically, that he prefers the economic outcomes achieved under the hawkish central banker to those that could have been obtained under a central banker with views closer to his own and those of the public.

But inflation hawks can prove troublesome, too, as Bernanke notes. For example, when they are first appointed, they may be so gung-ho to establish their inflation-fighting credentials that they overstate an economy's problems just to earn their hawkish bona fides. Or, later in their term, they may react too aggressively when faced with an adverse shock to the economy.

What to do? Bernanke cites the work of Carl Walsh, who offered the idea of establishing a simple contract between the central bank and the government that ties central bankers' compensation to the inflation rate: The higher inflation goes, the bigger bite that comes out of the ol' paycheck. The benefit here is that everyone—from the central bank to the government to Wall Street to the U.S. public—would understand the nature of the contract, and they would not have to worry about whether policymakers were credible because, in effect, credibility would be baked into the contract.

Alan Blinder, in his contribution to the conference, reinforces the importance of credible inflation-fighting, but reminds us that flexibility is still an important nuance to monetary policymaking. The worlds encountered by Paul Volcker and Alan Greenspan were different, he says. While Volcker's clear challenge was to curb inflation, Greenspan faced two stock market crashes, a period when banks' balance sheets were weakening in the early 1990s, international financial crises, a surprising uptick in productivity and a scare from the deflation bogeyman, along with the need to finesse a couple of soft landings for the economy. In other words, these are not all nails in need of the inflation fighter's mighty hammer.

So, after stressing that the first lesson of the Volcker era is that the central bank needs to be single-minded about fighting inflation, Blinder lays out the apparent contradiction that "flexibility in monetary policy is very important" and, further, that "fine tuning is actually possible."

In all, Blinder offers 11 lessons from the Volcker era, but for now we'll jump to his final message:

[G]reater transparency can enhance the effectiveness of monetary policy. The old tradition at central banks was, of course, to say little and to say it cryptically. That's how the temple kept secrets. There is still far too much secrecy for my taste. But the unmistakable trend, both at the Fed and around the world, is toward greater transparency.

In his contribution to the conference, Roger Ferguson offers keen insight into what it takes to be an effective Fed chairman by suggesting that the chief monetary policymaker needs more than just an academic understanding of the economy; the Fed chairman has to have a practical understanding of how the economy works and must be able to "withstand political pressures." That last point holds true for all FOMC members, Ferguson suggests.

Ferguson also gives a useful review of the debate over inflation targeting. (Other contributors to this volume also discuss this relevant topic, and Region readers will recall that this bank's president, Gary Stern, has proposed adoption of inflation targets.) The Fed vice chairman concludes that questions of implementation and empirical evidence weigh against inflation targeting as a necessary
inflation-fighting tool. To wit:

I submit that the adoption of a numerical inflation target does not promise any obvious incremental benefits, at least in countries that have already achieved reasonable price stability. That said, a continuing commitment to price stability is certainly important, and the Federal Reserve has established a solid record of such commitment.

We'll take a look at just one more paper before concluding with some more colorful anecdotes about Volcker and his era, and that is to visit the contributions of eminent economist and economic historian Anna Schwartz. Schwartz is one of the few people qualified to review the Volcker legacy in terms of its "clash" with monetarism (a word she uses in her paper's title). Twenty-five years later, she provocatively asks, "[H]as the contest between the U.S. central bank and its critics been resolved?"

Schwartz reviews the monetarist critique before and during the Volcker era, and the interested reader is commended to Schwartz's own engaging prose to best appreciate the monetarist arguments. The "litany of faults" that she lists with the pre-Volcker Fed includes the use of faulty guides to make monetary policy, open market directives subject to qualitative interpretation by the Open Market Desk at the New York Fed, a harmful short-term horizon, and oversteering to promote economic growth and to then fight the resultant inflation.

On Oct. 5, 1982, the Fed abandoned its new reserves-targeting procedure and went back to a policy of interest rate control, a move that Schwartz termed a "travesty." The Fed more often missed its monetary growth target than hit it, Schwartz notes, adding that "monetary growth fluctuated over a wide range."

In the end, the monetarist debate with the Fed and with the economics profession has waned, Schwartz says, but mostly because the profession now accepts the following beliefs:

• Money matters.
  
• Inflation can be controlled by monetary policy.
  
• There is no long-run trade-off between inflation and unemployment.
  
• There is a distinction between nominal and real interest rates.
  
• Policy rules can stabilize monetary policy.

Once again, those ideas may seem obvious to economists and policymakers at work today, but they were not conventional wisdom 25 years ago. Schwartz concludes thusly:

What does this development teach us about monetarism's past disagreements with the Fed? Monetarism lost the battle for a monetary aggregate to replace the federal funds rate as the Fed's target, but it won the real goal that it sought, namely, long-run stable growth of an aggregate with no predictive power for prices.

Will this happy outcome endure? Time will tell.

Of Popes and purple hearts

An added bonus of the St. Louis Fed's Review is the insight it brings to the era and to the people involved. As mentioned earlier, the stories from Joe Coyne, the Board's former frontline media representative, are especially revealing and include "the Pope, Gail Cincotta and consumer activists, purple hearts, two-by-fours, keys, and a corporal in a John Wayne movie."

The curious reader will have to read Coyne's essay for all those stories, but we'll quickly describe a couple. As to the Pope, it so happened that the leader of the Roman Catholic Church was in Washington that weekend and, in consequence, the major news organizations were already quite busy. At the conclusion of the Oct. 6 meeting (roughly 4 p.m.), Coyne began phoning media outlets to alert them about an important news conference scheduled for 6 p.m. (Keep in mind that there were no cell phones or e-mail in those days, Coyne notes.) Soon, the CBS Washington Bureau chief was on the line with Coyne, protesting that the Pope's visit had tied up his news team. "Without hesitating," Coyne recalls, "I said he would remember the press conference long after the Pope had left town. He sent the crew and never complained. I hope the Pope has forgiven me."

Coyne also describes meetings with consumer groups that were scheduled around the country so the Fed could describe its policies to the general public and, in effect, explain why some short-term pain would be better for everyone in the long run. The meetings included two senior officials from the Board and two from the Reserve Bank where each meeting was held. "As you might expect," Coyne writes, "the meetings ranged from tense to extremely tense to sometimes threatening." At some point, someone at the Board got the idea that purple hearts were in order for those who survived these meetings, and purple pin cushions reshaped to represent a heart were ceremoniously awarded to those who survived such ordeals.

Other anecdotes appear throughout the Review. For example, Edwin Truman, then director of the Board's Division of International Finance, recounts a conference in Belgrade immediately preceding the Oct. 6, 1979, meeting, where former Fed Chairman Arthur Burns presented a four-part proposal for how the United States should deal with inflation. "Volcker arrived late at the lecture," Truman recounts, "sat on the floor leaning against a wall, picked up a copy of Burns's speech, skimmed through it, and tossed it back on the floor with the comment, 'I'm doing it all wrong.' I was sitting a few feet away and was one of the few who heard him and understood what he really meant."

For readers who want to understand what Volcker really meant and want a better understanding of the "whys and wherefores" of current monetary policymaking, they can do no better than pick up a copy of this St. Louis Review and spend some time with its many and varied contributions. The issues debated in these pages are as alive today as when they were first introduced, and will likely be so for years to come. As Chairman Greenspan notes: "An appreciation of our history is, after all, an invaluable guide to sound policies for a better future."