From the Great Inflation to the Great Moderation

During Marvin Goodfriend's more than 25 years at the Richmond Fed, US monetary policy changed from the activist go-stop policy of the 1970s to the Volcker-Greenspan policy of creating an expectation of price stability. Marvin both documented this radical transformation and played a key role — through policy analysis and analytical work — in its becoming the consensus view of academics and policymakers. In this essay, I review the Volcker and Greenspan policy accomplishments and Marvin's contributions, referring to 10 of his papers in the process.

Marvin's genius and gift for making substantive contributions lay in his ability to draw from diverse methodological traditions. Milton Friedman identified two broad classes of approaches to identifying causation in economics. The Walrasian approach requires from the beginning explicit specification of a general equilibrium model, in contemporary terms, an optimizing, dynamic, stochastic, general equilibrium model. The Marshallian approach, favored by Friedman, requires from the beginning a search for empirical regularities and then uses an historical narrative organized around events that have the element of semicontrolled experiments.¹ Marvin's ability to meld these two approaches is illustrated by the way in which he integrated theory and historical narrative, respectively, in Goodfriend and King (1997) and Goodfriend (2005).

While Marvin's research used both theory and history, his approach to both was grounded in monetarist principles, Bill Poole having been an important influence in the Brown PhD program.

The consensus among monetary economists that central banks are responsible for inflation is built on both theory and evidence. Above all, there is the substantial body of evidence from the inflationary experiences of a great many nations, including the widespread inflation in the industrialized world during the 1960s and 1970s, showing that sustained inflation is always associated with excessive money growth. The evidence also clearly indicates that inflation is stopped by slowing the growth of the money supply.²

Money remains in the background for much of this essay, but I will argue that these monetarist principles are consistent even with Marvin's work on the New Keynesian models in which money was ostensibly absent.

The transformation of monetary policy from pre- to post-Volcker

Marvin used the term "go-stop" to describe FOMC policy in the pre-Volcker period.³ He describes it as follows:

Inflation would rise slowly as monetary policy stimulated employment in the go phase of the policy cycle. By the time the public and Fed became sufficiently concerned about rising inflation for monetary policy to act against it, pricing decisions had already begun to embody higher inflation expectations. At that point, a given degree of restraint on inflation required a more aggressive increase in short-term interest rates, with greater risk of recession.⁴

The go-stop character of monetary policy was based on achieving a socially desirable low rate of unemployment and on the consensus that cost-push pressures drove inflation. The latter assumption meant that achievement of price stability would incur a high cost in terms of unemployment. With go-stop policy, inflation drifted up in the 1970s, causing the loss of a stable nominal anchor.

The absence of an anchor for inflation caused inflation expectations and long bond rates to fluctuate widely.… [It] became increasingly difficult to track the public's inflation expectations to tell how nominal federal funds rate policy actions translated into real rate actions.⁵

Paul Volcker became FOMC chairman in August 1979. On October 6, 1979, the FOMC announced nonborrowed reserves procedures designed to ensure a deceleration in money growth. As Marvin wrote,

In October 1979 it was not at all clear how quickly the Volcker Fed could acquire credibility for low inflation, how costly a disinflation might be, or even whether it could succeed at all, given the pressure that would be brought to bear on the Fed as a result of the accompanying recession.⁶

Proponents of rational expectations argued that credibility for disinflation would greatly reduce the cost of disinflation. Goodfriend and King (2005) pointed out that the disinflation was not a good test of the proposition. Volcker could not commit to price stability because of uncertainty over the support of the political system.

The Volcker disinflation was ultimately successful. The Volcker-Greenspan monetary policy that followed ended the instability of the 1970s and created the Great Moderation. Marvin documented that transition, for example, in Goodfriend (2005). In Marvin's telling, monetarism was central to the Volcker disinflation:

Monetarist theory and evidence on money supply and demand, and on the relationship between money and inflation, encouraged the Volcker Fed to act against inflation. The successful stabilization and eventual elimination of inflation at reasonable cost in light of subsequent benefits, without wage and price controls, and without supportive fiscal policy actions, vindicated the main monetarist message…. By assembling a convincing body of theory and evidence that controlling money was necessary and sufficient for controlling inflation, and that a central bank could control money, monetarists laid the groundwork for the Volcker Fed to take responsibility for inflation after October 1979 and bring it down.⁷

Pre-Volcker, the activist policy of discretionarily balancing off independent targets for low unemployment and low inflation foundered as the inflationary expectations of the public rose and offset the stimulative effects of monetary expansion, leaving only higher inflation with no benefit in terms of lower unemployment. Marvin wrote,

Over time, deliberately expansionary monetary policy in the 'go' phase of the policy cycle came to be anticipated by workers and firms. Workers learned to take advantage of tight labor markets to make higher wage demands, and firms took advantage of tight product markets to pass along higher costs in higher prices. Increasingly aggressive wage- and price-setting behavior tended to neutralize the favorable employment effects of expansionary policy.⁸

This process led to expected and actual inflation becoming unanchored.

Reanchoring inflationary expectations required abandoning the prior activist policy with its characteristic of expansionary monetary policy in recoveries and contractionary monetary policy in response to the resulting inflation. As made evident in the preemptive increases in the funds rate in economic recoveries intended to prevent the emergence of inflation and to forestall an increase in expected inflation, policy maintained a neutral character. Marvin summarized:

For the Volcker Fed … its room to maneuver between fighting inflation and fighting recession disappeared. In effect, the Fed lost the leeway to choose between stimulating employment in the go phase of the policy cycle and fighting inflation in the stop phase.⁹

The discipline imposed on monetary policy in the Volcker-Greenspan era came from the desire to short circuit the process whereby expected inflation would rise with monetary stimulus and rising inflation. Stabilizing expected inflation in a way consistent with a return to price stability required preemptive increases in the funds rate. Once a policy of price stability became fully credible starting in 1995, this meant raising interest rates vigorously in economic recovery when signs of tightness emerged in labor and product markets. "The Fed has learned to adjust interest rates more preemptively since October 1979 … and inflationary go-stop policy cycles are no more."¹⁰

The Great Moderation through the lens of the NK model

The shift in the monetary regime to focusing on price stability from discretionarily trading off between unemployment and inflation changed the intellectual consensus. The profession became receptive to the development of the New Keynesian (NK) dynamic stochastic general equilibrium (DSGE) model. Goodfriend and King (1997) used the term "New Neoclassical Synthesis" to characterize the model and to emphasize the sharp break with the prior class of Keynesian models.¹¹

Optimal policy in the NK model

A central property of the basic NK model, as exposited by Goodfriend and King (1997), is that optimal monetary policy is neutral (see also King and Wolman, 1999). That is, it is nonactivist in that the optimal policy does not move between expansionary and contractionary monetary policy. Instead, policy remains focused on price stability and turns over the behavior of the real economy to the real business cycle core of the economy. In the basic NK model, a credible policy that stabilizes the price level keeps output at potential, even for shocks to aggregate supply.

Blanchard and Gali (2007) refer to the simultaneous occurrence of price stability and a zero output gap in the basic NK model as "divine coincidence." They treat markup shocks as classic supply shocks requiring a trade-off between inflation and employment. Price stability is nonoptimal in that it requires increases in unemployment in the event of supply shocks. In the spirit of the Goodfriend-King (1997) version of the NK model, however, the central bank can let the shocks pass through to the price level and over time they average out as noise. "If one argues that some costs flow directly to prices in a perfectly competitive sector, then theory suggests that the central bank should consider stabilizing only a 'core' index of monopolistically competitive sticky prices."¹² In Goodfriend (2005, p. 254) Marvin lists modifications to the basic model that can produce a short-run trade-off between inflation and unemployment and explains why they are unlikely to be important in practice.

Because the NK Phillips curve makes current inflation depend upon expected future inflation and the markup (the excess of price over marginal cost), a policy of price stability entails stabilization of firms' markup.¹³ The markup is a latent (nonobservable) variable. However, a rule that maintains the output gap equal to zero through price stability is equivalent to a rule that maintains actual and expected real rates of interest equal to their natural counterparts. Practical implementation of a rule that provides for price stability then requires a reaction function that provides for a stable nominal anchor and that causes the real funds rate to track the natural rate of interest.

How policy worked in practice

In the Great Moderation of the Volcker-Greenspan era, the FOMC did not literally implement a rule that directly targeted the price level. Since the chairmanship of William McChesney Martin, the FOMC's reaction function has always worked on the lean-against-the-wind (LAW) principle.¹⁴ Specifically, when the economy was growing above potential as evidenced by a sustained increase in the rate of resource utilization (a declining unemployment rate), the FOMC raised the funds rate in measured increments. It then watched bond markets to ascertain that markets believed the FOMC would raise rates over time sufficiently to maintain price stability.¹⁵ A converse statement holds for weakness.

The NK model provides the economic intuition for LAW procedures in that above-trend output growth is associated with optimism about the future and below-trend growth with pessimism about the future. Optimism is associated with a relatively high natural rate of interest while pessimism is associated with a relatively low natural rate of interest, as Marvin discusses, for example, in Goodfriend (2004).¹⁶ LAW procedures are then the foundation for tracking the natural rate of interest. The central modification to LAW that differentiated go-stop monetary policy from the successor policy directed at the reestablishment of price stability was preemptive increases in the funds rate intended to prevent the revival of inflation. In terms of the NK model, such preemptive tightening allows the FOMC to track the natural rate of interest.¹⁷

Preemption began with the FOMC's response to inflation scares.¹⁸ Marvin wrote:

The successful containment of the 1983-84 inflation scare was the most remarkable feature of the Volcker disinflation. The Fed had succeeded in reducing inflation temporarily in many preceding go-stop policy cycles. Preemptive interest rate policy actions in 1983-84 finally put an end to inflationary go-stop policy. This success was particularly important for the future because it showed that well-timed, aggressive interest rate policy actions could defuse an inflation scare and preempt rising inflation without creating a recession.¹⁹

Preemptive increases in the funds rate do not limit sustainable growth in employment. Marvin also highlighted the preemptive tightening in 1994.

The economic expansion gathered strength in late 1993. The zero real federal funds rate was no longer needed and would become inflationary if left in place. The Fed began to raise the federal funds rate in February 1994, taking it in seven steps from 3 percent to 6 percent by February 1995. Inflation showed little tendency to accelerate and remained between 2.5 percent and 3 percent. Thus, the Fed's policy actions took the real federal funds rate from zero to a little more than 3 percent. The move raised real short-term interest rates to a range that could be considered neutral to mildly restrictive. In spite of the policy tightening, real GDP grew by 4 percent in 1994, up from 2.6 percent in 1993, and the unemployment rate fell from 6.6 percent to 5.6 percent from January to December 1994. ...

The 1994 tightening demonstrated that a well-timed preemptive increase in real short-term interest rates is nothing to be feared. In this case, it was needed to slow the growth of aggregate demand relative to aggregate supply to avert a buildup of inflationary pressures. By holding the line on inflation in 1994, preemptive policy actions laid the foundation for the boom that followed.²⁰

This discipline imposed on underlying LAW procedures contrasted with the discretion that characterized the go-stop policy of the 1970s. "[D]iscretion leads inexorably to go-stop policy that brings rising and unstable inflation and inflation expectations, with adverse consequences for interest rates and employment."²¹

However, there is an issue of political economy. Preemptive increases in the funds rate inevitably arouse populist criticism charging that the FOMC is increasing unemployment to fight a nonexistent inflation.

By successfully keeping inflation in check, preemptive policy actions necessarily appear to be busting ghosts. So the appearance of ghost busting is a consequence of good monetary policy.²²

What about money?

One notable aspect of NK models is that they do not contain money. Is there then a contradiction between Marvin's willingness to use NK models for policy analysis and his view that monetarism was central to the Volcker disinflation? No: under optimal policy in the basic NK model of Goodfriend and King (1997), money is a veil. It need not appear in the model.²³ The reason is that the optimal monetary rule ensures monetary control. "Under a neutral policy, the monetary authority accommodates variations in money demand to insure that excesses or shortages of money do not create aggregate demand disturbance."²⁴ With the output gap equal to zero, there is no excess demand or supply in the goods market to spill over and create a corresponding excess supply or demand in the bond market. With no excess supply or demand in the bond market, there are no excesses or deficiencies for the Fed to monetize or demonetize as a consequence of defending its interest rate target, thereby creating destabilizing changes in money.

Contrary to the expectations of monetarists, the required monetary control in the Volcker-Greenspan era did not occur through adoption by the Fed of a reserves aggregate as a target for achieving substantive money targets. The control occurred indirectly through a rule that provided for a stable nominal anchor through commitment to maintenance of an expectation of nominal stability, ultimately price stability. With that nominal expectational stability, the Fed could implement operating procedures that caused the real funds rate to track the natural rate of interest, thereby turning over the determination of real variables such as output and employment to the unfettered operation of the price system. In the 1970s, the monetary regime entailed discretionarily trading off between objectives of low unemployment and low inflation presumed driven by cost-push forces. This activist policy created destabilizing fluctuations in money. The neutral policy pursued in the Volcker-Greenspan era disciplined money creation so that it did not become a source of instability.

Conclusion

I close with a passage from Goodfriend (1997), which seems especially relevant today, in light of the FOMC's movement away from preemptive funds rate increases. Marvin wrote,

The Fed has acquired credibility since the early 1980s by consistently taking policy actions to hold inflation in check. Experience shows that the guiding principle for monetary policy is to preempt rising inflation. The go-stop policy experience teaches that waiting until the public acknowledges rising inflation to be a problem is to wait too long. At that point, the higher inflation becomes entrenched and must be counteracted by corrective policy actions more likely to depress economic activity.²⁵

It is indeed a tragedy that Marvin is no longer here to help us learn from the "Odyssey" of monetary policy not only in the 20th century, but also the 21st century. But we do have the gift of his body of work, whose continued relevance for thinking about monetary policy I have tried to convey in this essay.

References

Aoki, Kosuke. 2001. "Optimal Monetary Policy Responses to Relative-Price Changes." Journal of Monetary Economics 48, no. 1 (August): 55-80.

Blanchard, Olivier, and Jordi Gali. 2007. "Real Wage Rigidities and the New Keynesian Model." Journal of Money, Credit, and Banking 39 (February): 35-65.

Friedman, Milton. 1960. A Program for Monetary Stability. New York: Fordham University Press.

Friedman, Milton, and Anna J. Schwartz. 1963. A Monetary History of the United States, 1867-1960. Princeton: Princeton University Press.

Goodfriend, Marvin. 1991. "Interest Rates and the Conduct of Monetary Policy." Carnegie-Rochester Conference Series on Public Policy 34 (Spring): 7-30.

Goodfriend, Marvin. 1993. "Interest Rate Policy and the Inflation Scare Problem." Federal Reserve Bank of Richmond Economic Quarterly 79, no. 1 (Winter): 1-24.

Goodfriend, Marvin. 1997. "Monetary Policy Comes of Age: A 20th Century Odyssey." Federal Reserve Bank of Richmond Economic Quarterly 83, no. 1 (Winter): 1-22.

Goodfriend, Marvin. 2002. "The Phases of U.S. Monetary Policy: 1987 to 2001." Federal Reserve Bank of Richmond Economic Quarterly 88, no. 4 (Fall): 1-16.

Goodfriend, Marvin. 2004. "Monetary Policy in the New Neoclassical Synthesis: A Primer." Federal Reserve Bank of Richmond Economic Quarterly 90, no. 3 (Summer): 21-45, reprinted from International Finance, 2002, 5, 165-92.

Goodfriend, Marvin. 2005. "The Monetary Policy Debate since October 1979: Lessons for Theory and Practice." Paper prepared for "Reflections on Monetary Policy: 25 Years after October 1979," Federal Reserve Bank of St. Louis Review 87, no. 2 (March/April): 243-62.

Goodfriend, Marvin. 2013. "The Great Inflation Drift." In The Great Inflation: The Rebirth of Modern Central Banking, edited by Michael D. Bordo and Athanasios Orphanides, 181-215. Chicago: The University of Chicago Press.

Goodfriend, Marvin, and Robert G. King. 1997. "The New Neoclassical Synthesis." In NBER Macroeconomics Annual 1997, Volume 12, edited by Ben S. Bernanke and Julio Rotemberg, 231-296. Cambridge: MIT Press.

Goodfriend, Marvin, and Robert G. King. 2001. "The Case for Price Stability." In Why Price Stability? Proceedings of the First ECB Central Banking Conference, edited by A. Garcia-Herrero, V. Gaspar, L. Hoogduin, J. Morgan, and B. Winkler, 53-94. Frankfurt, Germany: European Central Bank; NBER Working Paper 8423, National Bureau of Economic Research, August.

Goodfriend, Marvin, and Robert G. King. 2005. "The Incredible Volcker Disinflation." Journal of Monetary Economics 52, no. 5 (July): 981-1015.

Hetzel, Robert L. 2008. The Monetary Policy of the Federal Reserve: A History. Cambridge: Cambridge University Press, 2008.

Hetzel, Robert L. 2012. The Great Recession: Market Failure or Policy Failure? Cambridge: Cambridge University Press, 2012.

Hetzel, Robert L. 2022. The Federal Reserve System. A New History. University of Chicago Press, forthcoming.

King, Robert G., and Alexander L. Wolman. 1999. "What Should the Monetary Authority Do When Prices Are Sticky?" In Monetary Policy Rules, edited by John B. Taylor, 349-404. Chicago: University of Chicago Press.

Cite as: Hetzel, Robert L. 2022. "From the Great Inflation to the Great Moderation." In Essays in Honor of Marvin Goodfriend: Economist and Central Banker, edited by Robert G. King and Alexander L. Wolman. Richmond, Va.: Federal Reserve Bank of Richmond.