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Speaking of the Economy
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Speaking of the Economy
March 8, 2023

A View of Monetary History (Part 2)

Audiences: Economists, General Public

Robert Hetzel reviews the evolution of monetary policymaking through the lens of his new book, The Federal Reserve: A New History. In part two of this two-part discussion, he focuses on the Fed's policies during the Great Inflation and the Great Moderation and after the Great Recession, as well as the role of the Federal Reserve Bank of Richmond during these periods. Hetzel was a senior economist and research advisor at the Richmond Fed from 1975 to 2018.



Tim Sablik: Hello, I'm Tim Sablik, a senior economics writer at the Richmond Fed. My guest today is Robert Hetzel, a visiting scholar at the Federal Reserve Bank of Chicago, a senior affiliated scholar at the Mercatus Center at George Mason University, and a fellow at the Institute for Applied Economics, Global Health and the Study of Business Enterprise at Johns Hopkins University.

Bob is regarded as a leading expert in monetary history, having studied the policies that the Fed has used to maintain price stability and full employment over its history. He has interviewed prominent figures in monetary policy as well as lived through key moments himself as a senior economist and research advisor at the Richmond Fed from 1975 to 2018.

I talked with Bob about his new book, "The Federal Reserve: A New History." Our conversation spanned several decades of the Fed's more recent history, requiring us to break it up into two episodes. This is part two of that discussion, focusing on the Great Inflation of the 1970s and bringing us to the present. I encourage you to listen to the previous episode where we discussed the Fed's struggles for policy independence in the 1950s and the 1960s.

Since we are moving into modern-day monetary policy, I should note that Bob Hetzel's views do not reflect the views of the Federal Reserve Bank of Richmond or the Federal Reserve System. With that in mind, let's pick up the conversation now.

Sablik: It seems like this "lean against the wind with trade-offs" had become the governing philosophy of the Fed by the end of the 1960s. And then the 1970s was a decade that came to be known as the Great Inflation, a decade of high and volatile inflation that's widely viewed as a failure of monetary policy today.

This is also the period when you first came to the Richmond Fed, so you had, I would say, a front row seat to many of the big events in this decade. How do you interpret that period in your book, and what role did Richmond play in the policy debates of that era?

Robert Hetzel: Just like today, society was very divided. It was divided over the Vietnam War. It was divided over a militant civil rights movement. So, there was a political consensus that to keep the lid on social discontent, you needed to keep the unemployment rate low, at least as low as 4 percent.

As you go into the '70s, the unemployment rate doesn't stay at 4 percent. It goes up to 6 percent and you're getting inflation. In the Keynesian environment at the time, the assumption is that if 4 percent is wanted and you've got 6 percent actual inflation, you've got a lot of slack in the economy. Inflation can't be due to aggregate demand — too much money chasing too few goods. It's got to be doing a cost push.

Sablik: Some of our listeners may have not heard of the term "cost push inflation" before. Usually, when the supply of goods and services falls or production costs increase, suppliers increase their prices and demand eventually falls. However, if demand remains the same or increases in the face of higher prices, that can drive up prices further.

Arthur Burns was FOMC chair at this time. What did he do?

Hetzel: Burns was always pushing for wage and price controls, some kind of intervention from the Nixon administration and Congress. This underlying presumption that inflation is driven by cost push pressures meant that if you are going to reduce inflation, to return to price stability, you'd have to have high unemployment and that would be socially unacceptable. So, the Fed — mostly under Burns but later under G. William Miller — would go period by period trying to accommodate inflation so it didn't have to raise unemployment, so it can achieve a socially acceptable mix between inflation and unemployment.

The whole theory behind that was something called the Phillips curve. That is, you could predict from the amount of slack in the economy the amount of inflation you would get. Those predictions were always way too optimistic. And the implication of that — and this gets a little nerdy — if you're controlling inflation by controlling slack in the economy, inflation is a real phenomenon. Money growth just accommodates the inflation that's created by costs. If you raise interest rates and lower money growth, you're going to get a socially unacceptable level of unemployment.

So, you've got an environment in which the Fed doesn't think of inflation as a monetary phenomenon. It's not responsible for inflation. By the time you get to the end of the '70s, inflation is very near 10 percent.

The Richmond Fed did not sign off on what I call "lean against the wind with trade-offs." Richmond maintained its belief in the desirability of price stability and allowing markets to work, not interfering with the operation of the price system. The original bank that argued that inflation was a monetary phenomenon and to control it you'd have to control money creation, that was the St. Louis Fed. That came on pretty early. But Richmond was the next bank after the St. Louis Fed. And that was important. Richmond really became a leader.

The president of the St. Louis Fed, a man named Daryl Francis, he was a committed monetarist. He would come to FOMC meetings and read a statement, and then basically sign off. As Bob Black, president of the Richmond Fed, told me, everybody knew what he was going to say — he would just say, well, we need lower money growth. Members would just take out their tin ear and tune him out.

Now Richmond was different. In those days, you'd have a bank president who was not an economist — some banker or a lawyer or something — and you'd have economists in the research department. Well, that changed with Richmond. Richmond really set a new standard. Our president, Bob Black, was an economist and he was willing to talk about monetary policy in a give-and-take way with the economists. So, when he got into an FOMC meeting and read his statement, he didn't just sign off. He would actually take part in the give-and-take debate. That's where you exercise the real influence.

Sablik: That's a good segue to the next period of the 1980s and 1990s, a period known as the Great Moderation where the Fed successfully brought inflation down under the leadership of Paul Volcker and Alan Greenspan. What was the key to the Fed's success in that era? You also mentioned that Richmond also played a role in driving some of those policy changes.

Hetzel: By the time that Volcker became FOMC chair in August of 1979, the Fed had lost a stable nominal anchor. That is, as inflation rose, expectations of inflation rose. It wasn't like financial markets thought that if inflation rose, yeah it would come back down. We didn't have the kind of monetary regime that would enforce that.

Volcker was very concerned about inflationary expectations having become unanchored, destabilized. He was especially concerned that, in 1979, you had an oil price shock and inflation shock and he didn't want that high inflation to pass into wage setting. Because of the past and the wage setting and the wage contracts, he realized it would be extraordinarily difficult to lower inflation and maybe he wouldn't be able to do it — society wouldn't put up with it.

Volcker was very focused on inflationary expectations. That's what brought him back to the earlier Martin policies that I call "lean against the wind with credibility." That discipline on restoring nominal expectational stability created this return to pre-emptive increases in the funds rate to prevent the emergence of inflation.

We were providing a stable nominal anchor in terms of the expectations of price stability. And Volcker and Greenspan both said you want to get back to a world where people don't think about inflation because it's not a problem. When firms go to set prices, they set them based on what's a good relative price for them, not what they think inflation is going to be.

And, sure, the Fed has a dual mandate: price stability and maximum employment. But do you then fulfill the maximum employment mandate by trading off between inflation and unemployment? Or do you get it by focusing on price stability and letting the maximum employment objective emerge out of the operation of a healthy economy. That latter is what produced the Great Moderation.

When Volcker retired, there was a retirement banquet for him and he came around to thank people. When he got to Bob Black, he said, "Thank you Bob for being my conscience."

Very early on, Richmond was the bank that pushed for an inflation target. We really began to push for it in in 1994. [Former Richmond Fed President] Al Broaddus told me that when the discussion would come around and Greenspan would look at Bob Black and he would just say, "Oh, no, I feel it coming. Richmond is going to push for an inflation target."

Sablik: Marvin Goodfriend, who was head of the Richmond Fed's Research department, worked with Robert King of Boston University to develop a new way of looking at monetary policy that you alluded to earlier. This is the idea that maintaining low and stable inflation should be a central bank's primary objective because the price system will work itself out. Can you elaborate on that?

Hetzel: This gets into the role of models and how we use models to think about monetary policy.

When you think about the optimal monetary standard and the desirable monetary policy that comes out of that, you really need to start in a very general way with a model. The model forces you to do two things. It forces you to ask whether inflation is a monetary or non-monetary phenomenon and it forces you to think about the price system. We do not live in a command-and-control economy. We don't have rationing. We have to achieve our objectives through the way our reaction function interacts with the price system.

You got to make one of two fundamental decisions. You got to believe that the stabilizing properties of the price system work to preserve full employment as long as the Fed doesn't interfere with their operation. Or, you got to believe that the stabilizing properties of the price system are weak and the Fed and Congress through fiscal policy need to supersede their operation to achieve full employment, which as we talked about requires a trade-off between inflation and unemployment.

The Goodfriend-King paper, which came out in 1997, used the New Keynesian model, which again forces you to think about the nature of inflation and how we interact with the price system. In their model, if policy focused on price stability, the unfettered operation of the price system would allow the real business cycle core of the economy to run and determine employment and output. That was the optimal standard.

Sablik: Yeah, that's a theme that runs through your book — the need for a model for thinking about monetary policy. And it brings us to the present day. A lot of economists mark the end of the Great Moderation with the recession of 2007-2009. How did the Fed's approach to monetary policy change following that event?

Hetzel: Here is where the Richmond tradition challenges us to think about the kind of monetary policy that we've conducted since the Great Recession.

Let's go back to William McChesney Martin and the Treasury-Fed Accord of 1951. Martin wanted to advertise to the Treasury that we were not just your handmaiden for keeping interest rates low. The Fed didn't want anything to do with the allocation of credit. So, up until 2008, the Fed absolutely kept out of intervening in credit markets.

Marvin Goodfriend and Al Broaddus wrote a series of influential papers, arguing that we needed a separation between monetary policy and credit policy. Monetary policy was how we controlled money creation through the control of the liability side of our balance sheet. Credit policy was determined by how we allocated our asset purchases on the asset side of our balance sheet. So, for example, should we load up on mortgage-backed securities or should we follow the William McChesney Martin policy called "bills only," only buying short-term Treasury securities?

Sablik: Moving on from the recession itself into the recovery and then into the more recent COVID-19 pandemic, what are the lessons that you take away from those periods?

Hetzel: When you get into the pandemic monetary policy, [Fed Chair Jerome] Powell and [former Fed Governor] Lael Brainard really wanted an expansionary monetary policy to push the unemployment rate down from 14.7 percent in April of 2020 to the pre-pandemic level of 3.5 percent. They looked back at the recovery from the Great Recession and said oh my goodness, you had 1.5 percent or 1.25 percent inflation. We could have gotten the unemployment rate back down much faster if we'd been willing to have an expansionary monetary policy and let inflation move up. The feeling was we shouldn't repeat the so-called mistakes of the Great Recovery, which required a long time for the unemployment rate to recover. We can push the unemployment rate down to its pre-pandemic level of 3.5 percent, at least, without inflation.

So, we implemented a very expansionary monetary policy, which included a very significant monetization of the pandemic transfer payments that were authorized by Congress. With a monetary policy where we're keeping the funds rate at zero, promising more for longer, in that kind of environment if you buy a lot of government debt, well, that's helicopter money. The difference between the United States and Zimbabwe is a difference in degree, not in kind.

And so, from this earlier monetarist's perspective of the need to control money creation, the reason we're having trouble with inflation now is underlying inflation came out from an overly expansionary monetary policy. Effectively, we repeated the mistakes of the 1970s.

Sablik: Bob, thanks so much for coming on the show to share these insights from your book and from your time at Richmond.

Hetzel: Thank you.

Sablik: Listeners can check out Bob's book, The Federal Reserve: A New History, which is available now. And if you enjoyed this episode, please consider leaving us a rating and review on your podcast app.

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