The myth of Volcker’s 1979 assault on inflation

Commenter Russ Anderson pointed me toward a Fed publication that discusses the Volcker disinflation:

Twenty-five years ago, on October 6, 1979, the Federal Reserve adopted new policy procedures that led to skyrocketing interest rates and two back-to-back recessions but that also broke the back of inflation and ushered in the environment of low inflation and general economic stability the United States has enjoyed for nearly two decades.

This may be technically accurate, but it’s highly misleading.  It creates the impression that Fed policy became contractionary in 1979 and that this gradually broke the back of inflation.  But this simply isn’t so; monetary policy during 1979-81 was highly expansionary, as evidenced by rapid inflation and NGDP growth.  The Fed only because serious about inflation in mid-1981, when it raised real interest rates sharply.  This immediately broke the back of inflation.  So much for long and variable lags.

The picture is complicated by two factors that seem to support the official narrative:

1.  Monetary policy was briefly tightened in late 1979 and early 1980.

2.  There was a brief recession in early 1980.

Both of those facts are true, but highly misleading.  The tight money of late 1979 was not really all that tight, and it lasted very briefly.  By late-1980 monetary policy was highly expansionary, indeed perhaps the most expansionary in my lifetime.  Only in mid-1981 did the Fed seriously commit to tight money.

The recession of early 1980 was the shortest and mildest recession of the post-war era.  And it occurred against a backdrop of deindustrialization in the rust belt, and punishingly high taxes (MTRs) on capital.  The unemployment rate rose to a peak of 7.8%, but it was nearly 6% during the 1979 boom, evidence that President Carter’s bad supply-side policies were hurting the economy.  In addition to high tax rates, we had energy price controls.

Although the recession officially began in January 1980, RGDP actually rose in the first quarter.  As late as March 1980 few expected a recession, the economy seemed to be in an inflationary boom.  Yes, the Fed raised the discount rate from 12% to 13% in mid-February, but about the same time the January CPI numbers came in at an 18% annual rate.  Gold peaked at $850 in January.  Thus in mid-March Carter put credit controls into effect to try to slow the economy and this pushed RGDP down at a 8.4% rate in the second quarter.  Soon it became clear we were in recession, and the controls were quickly phased out.  The recession was over by July, and housing and auto production recovered quickly.  Nevertheless, during the ensuing recovery unemployment leveled off in the 7% to 7.5% range, despite ultra-easy money.

I’m probably the only person who’s ever called monetary policy during 1980-81 “ultra-easy.”  This is right smack dab in the middle of the infamous Monetarist Experiment of 1979-82, the one that “broke the back of inflation.”  But facts are stubborn things.

In mid-1980 the Fed panicked at rising unemployment, and cut interest rates back into the single digits, despite 13% CPI inflation during 1980.  The result was predictable.  NGDP started recovering briskly in the third quarter.  But it was the next two quarters that were truly astounding; during 1980:4 and 1981:1, NGDP grew at an annual rate of:






That, my folks, is easy money.  I can’t even recall a faster rate over six months, although I don’t doubt there were some.  Think about how NGDP was “recovering” at just over 4% during 2010, and how the Fed huffed and puffed and pushed NGDP growth up to . . . 3.4% so far this year.

Yet this hyper-charged growth in AD did not significantly reduce unemployment.  Believe it or not, 7% was probably the natural unemployment rate by 1981.  It is not true that tight money cost Jimmy Carter the election.  His poor supply-side policies combined with his neglect of inflation produced a high misery index on election day.  That would have happened with or without Volcker.

In 1981 Reagan took over and supported Volcker’s fight against inflation.  By mid-1981 the Fed got serious, and real interest rates began rising sharply.  NGDP growth plunged into the low single digits.  During the recovery Volcker did allow relatively rapid NGDP growth, but not enough to re-ignite inflation.  Once RGDP growth leveled off, NGDP growth also slowed.  The recovery was also helped by Reagan’s good supply-side policies, such as much lower MTRs, energy price decontrol, and a tough stance toward public sector unions.  For the first time in my entire life the US began growing faster than most other industrialized countries.

So the 1979 assault on inflation is mostly myth.  It was just a blip in the ongoing Great Inflation, which didn’t peak until early 1981, when NGDP growth peaked.  Only in mid-1981 did the Fed get serious about inflation, and the results were almost instantaneous.  CPI inflation during Sept 1980- Sept. 1981 was 11%, over the following 12 months it plunged to less than 5%.  NGDP growth from 1981:3 to 1982:4 was at only a 3.4% annual rate.  Why did almost everyone get it wrong?  Because almost everyone believes in long and variable lags.  And many people focus on nominal interest rates.  And because it makes a good story.

PS.  You might ask if monetary stimulus today might lead to disappointing results, just like in 1980-81.  The answer is no, for reasons I’ll explain in the next post.

John Taylor on monetary stimulus when Reagan was president

Here is John Taylor discussing a paper by Martin Feldstein and James Stock:

NGDP and RGDP growth certainly did speed up after the 1982 recession, and Taylor’s right that this probably explains the faster recovery in the US as compared to Europe (although supply-side factors also played a role.)  In the first six quarters of the 1983 recovery NGDP growth averaged 11% and RGDP growth averaged 7.7%.  Taylor’s right that if you don’t have robust NGDP growth, you won’t get a satisfactory recovery.  For instance, NGDP growth has averaged just over 4% in the current “recovery,” which doesn’t even keep up with trend.

Taylor’s also right that level targeting is the way to go, and you want a policy that addresses both inflation and real growth.  Again, we can see the folly of growth rate targeting in this recovery.  Inflation has only averaged a bit over 1% during the past three years and yet the Fed doesn’t seem to be trying to catch-up for the shortfall.  Nor is the Fed taking real growth into account, even with a pure inflation target you could justify additional monetary stimulus.

And yet despite all this, some economists now insist that Fed policy is too expansionary, that the Fed should ignore its dual mandate and tighten monetary policy despite low inflation and 9% unemployment.

For instance, John Taylor.

HT:  Dilip

Hooters, Sarah Palin, and the smart money

There’s something about inflation targeting that causes otherwise sensible people to become slightly deranged.  On one side you have warning that no amount of money can cure Japanese-style deflation:

Yes, Hooters Inc. has made its way to Tokyo. Normally when hundreds of Japanese men huddle in line it’s for a new iPhone or video game. These days, it’s to be served beer and chicken wings by waitresses in white tank tops and orange short-shorts. The American chain is gaining popularity in Japan.

It’s also an unlikely sign that deflation will be with Japan for a long, long time.

Anyone who still thinks falling prices are a cyclical phenomenon isn’t looking closely. It’s secular, and the sudden ubiquity of discount outfits shows how Japanese consumption has become a race to the bottom of the pricing spectrum.

Japan used to be an automated-teller machine for brands like Prada, Gucci and Louis Vuitton. Women thought little of plopping down $2,000 for the latest fashions from Milan and Paris. Men didn’t blink at paying $200 for a tie. That’s all fashion-industry history now. Sliding wages and rising job insecurity brought budget-shopping into vogue.

No matter how much yen the Bank of Japan pumps into the economy, deflation deepens. It’s all about confidence, of which there is virtually none.

The hard core Keynesians say QE can’t work, because their models tell us it can’t work.  It’s just exchanging one zero rate asset for another.  Unfortunately their models are flawed, and we are seeing inflation expectations rise in response to QE, something that’s not supposed to happen.

At the other extreme you have Sarah Palin comparing Bernanke unfavorably to Ronald Reagan:

I’m deeply concerned about the Federal Reserve’s plans to buy up anywhere from $600 billion to as much as $1 trillion of government securities. The technical term for it is “quantitative easing.” It means our government is pumping money into the banking system by buying up treasury bonds. And where, you may ask, are we getting the money to pay for all this? We’re printing it out of thin air.

.   .   .

We shouldn’t be playing around with inflation. It’s not for nothing Reagan called it “as violent as a mugger, as frightening as an armed robber, and as deadly as a hit man.”

First of all, I think Reagan did a pretty good job on inflation.  Contrary to what some Democrats argue, it was Reagan, not Jimmy Carter that is responsible for the drop in inflation from about 10% in 1981 to about 4% in 1982.  He supported Volcker’s second attempt at tight money, whereas the first attempt was abandoned during the run-up to the 1980 presidential elections.  But let’s not overdo things.  After inflation was reduced to 4% in 1982, Reagan administration officials and conservative newspapers like the Wall Street Journal pressured the Fed to ease its monetary policy, and no further reductions in inflation were achieved.  Indeed inflation was closer to 5% by 1989 when Reagan left office.  In contrast, Bernanke has reduced core inflation to little more than 1%, and the TIPS market suggest inflation is likely to remain well under 2% over the next 5 years.  If low inflation is Sarah Palin’s goal, then Bernanke should be her hero, not Reagan.

Palin is echoing the views of many freshwater economists.  Their models tell them that Bernanke’s policies will produce high inflation.  Of course they also claim to believe in efficient markets, except when those markets tell them that their models are wrong.

So which is it, deflation or high inflation?  The smart money says neither:

Goldman Sachs Group Inc., which warned a month ago that the U.S. economic outlook was “fairly bad” at best, said the Federal Reserve’s decision to increase bond purchases will spur growth.

“Downside risks to the economic outlook have declined significantly,” Jan Hatzius, the New York-based chief U.S. economist at the company, wrote in an e-mail to clients. “As we move through 2011, the lagged effects of the renewed monetary easing combined with a gradual slowdown in the pace of private deleveraging should result in a substantial pickup in GDP growth.”

The Fed’s decision will lower the risk of deflation, Hatzius wrote. The Institute for Supply Management manufacturing index and the government’s employment report last week also show the economy is moving in the right direction, according to the report.

Hatzius defended Fed Chairman Ben S. Bernanke when others including E. Gerald Corrigan, former president of the New York Fed, have voiced concern that the central bank actions will lead to a surge in costs for goods and services. Bernanke on Nov. 6 dismissed the idea the central bank will increase prices to higher levels than it prefers.

There’s a reason GS makes more money that other banks, they use reality-based models, not faith-based models.  I am not sure why so many economists are predicting either no effect from QE, or high inflation.  This isn’t rocket science.  The Fed’s had an implicit inflation target of about 2% for decades.  When it’s too high they nudge it down, when it’s too low (as in 2002) they try to nudge it up.  I happen to support a NGDP target, but I’m not running the show.  Given their target, it’s no surprise they are trying to nudge inflation a little bit higher.  Markets currently expect only 1.7% inflation over the next 5 years, even given the recently announced QE.  Before rumors of QE started circulating, the expected inflation rate was only about 1.2% over 5 years.  Given how much we’ve undershot the Fed’s target over recent years; I’d like to see higher than 2% inflation.  But even I don’t think we’d need to go above 3% to get a robust recovery.  The markets and GS are telling us the same thing.  Trust the smart money, not the left and right wing ideologues.

QE has a modest positive impact, contrary to Keynesian models.  But it won’t produce high inflation, contrary to monetarist models.  Targeting the forecast—call it the Goldilocks model.

PS.  A year ago I talked to Bob Murphy about advertising.  He said he’d know I’d started taking ads when I put Sarah Palin in the title.  So I’m counting on a lot of hits—what could be better than combining Sarah Palin and Hooters!  I’ve only earned about $300 so far in Google Ads.  About $100 of that will go to pay down our national debt.  So if you want to help promote economic recovery and address our nation’s intractable fiscal problems, please tune in more often.

Who’s easy and who’s tight according to the WSJ

A few weeks ago I gave the Wall Street Journal a hard time over this recent quotation:

This is the real root of our current economic malaise””the conceit of Congress and the White House that more government spending, taxing and rule-making can force-feed economic expansion. Now that this great government experiment is so obviously failing, the politicians and the Wall Street Keynesians who cheered the stimulus are asking the Federal Reserve to save the day. Mr. Bernanke should tell them politely but firmly that his job is to maintain a stable price level, not to turn bad policy into wine.

Here was my reaction:

So that’s what it’s really all about.  I agree that Obama’s economic policies are highly counterproductive.  But unlike some conservatives I am not willing to unemploy millions of workers to win a policy argument.  I guess that’s the difference between hard core conservatives and pragmatic classical liberals like Friedman and I.  We should do the right thing and then put our trust in the democratic system.

Was I being unfair?  Maybe the WSJ would have made the same argument if a Republican was president.  After all, they say they favor a stable price level, and prices are still rising at 1%, and are expected to continue rising at that rate.  Do I have any right to infer they were trying to prevent Obama’s policies from looking more effective than they really are?

Fortunately, there is a very good way of showing whether they are advocating tight money for idealistic reasons, and not merely to insure the US economy is performing poorly in November.  A few weeks back I asked commenters to supply a WSJ editorial on monetary policy from back when Reagan was president.  Benjamin Cole came up with a very revealing editorial called “Who’s Easy” from December 18, 1984.  Here’s the first paragraph:

As the Federal Reserve Open Market Committee meets to chart monetary policy, real growth is equivocal and prices are rising at most slowly.  The arguments are for an easier policy, but probably the Fed thinks it’d eased already.

Sounds reasonable.  Presumably in December 1984 prices and output were rising much more slowly than the recent rates, and hence there was a need for easier money.  Just to make sure, let’s check the data:

Most recent 12 month growth rates, 2009:2 to 2010:2:

NGDP — 3.85%      RGDP — 2.98%     GDP deflator — 0.85%

Most recent 12 months growth rates as of December 1984 (1983:3 to 1984:3):

NGDP — 10.84%     RGDP — 6.87%   GDP deflator — 3.73%

Interesting that when Reagan was president the WSJ saw 4% inflation as too low, as prices that were “rising at most slowly.”  Now anything higher than 0.85% constitutes an abandonment of the Fed’s duty to maintain price stability.  If price stability is truly the goal, then why advocate greater monetary ease when inflation is almost 4%?   And if 6.87% real growth is “equivocal” then what is 2.98% growth?

I’m afraid the WSJ was wrong in 1984 (we didn’t need easier money) and they are wrong now (we do need easier money.)  I favor the same NGDP target whoever is president–a 5% growth trajectory, level targeting.  That means we need more than 5% NGDP growth for the next year or two.

Perhaps the WSJ got confused over interest rates; after all, they were much higher then than now.  Actually, in 1984 the WSJ had an almost Friedmanesque understanding that interest rates are highly misleading:

Interest rates, we should have learned these past few years, are not a reliable guide to monetary policy.

Unfortunately by 2010, when Obama was president, the WSJ seems to have forgotten what it once knew:

As for the current moment, the Fed has maintained its nearly zero interest rate target for 20 months, while expanding its balance sheet by some $2 trillion. By any definition this is historically easy monetary policy, and not without costs of its own.

The balance sheet numbers are not accurate, and even if they were they were, “historical” definitions of easy money would be meaningless once the Fed started paying interest on reserves.  I suppose they might argue that even though inflation is now low, easier money would lead to dangerous increases in inflation.  Here’s what the WSJ said in 1984:

For our part though, we have trouble understanding what’s wrong with economic growth.  What does the open market committee have against it?  In particular, growth is not inflationary; inflation is too many dollars chasing too few goods, and growth produces more goods.   When was it the committee came down from the mountain with stone tablets saying that 3% real growth is OK, but 4% will produce “bottlenecks and “overheating”?

Or “structural problems,” or “job mismatches,” I might add.  I can’t answer their question, you’ll have to ask the hawks at the Fed.

OK, so the WSJ has changed its mind on monetary policy.  Surely there is no reason to think that this reflects political bias.  It’s not like their earlier views were aimed at making Reagan’s policies look good.  Or were they?

Fed policymakers tend to discount any significant possibility of a 1985 recession, and on that assumption feel free to take another yank or two at the remnants of inflation.  But if they are wrong, the price will be high.  Indeed, a 1985 recession would probably mean not only the political failure of Reagan’s budget cuts, but an economic donnybrook with new international and banking-system problems.

Two terms jump out at me; ‘remnants’ of inflation, and the ‘political’ failure of Reagan’s budget cuts.

So what do you guys think?  Does political bias lead the WSJ to call for monetary policies that are good for the economy when Republicans are in office and bad for the economy when Democrats are in office?

Update:  The following information was posted by Mark Sadowski in the comment section.  I thought it worth repeating here:

The WSJ wrote this in April 2004 after ten months of an unprecedentedly low 1% fed funds rate:

“In many respects, the Fed can be more patient because the risks of waiting are lower. Back in 1994, hardly anyone at the Fed was comfortable with allowing inflation “” then 3% “” to rise; many wanted it to fall. Today, no one at the Fed wants less inflation; some want a bit more to minimize the deflation risk. Back then, hardly anyone at the Fed suspected the U.S. economy was enjoying an epochal surge in productivity that would allow faster growth and bigger wage increases without more inflation. Today, everyone sees the productivity surge; the only question is how much of it will persist.

Still, the case for keeping rates at 1% is diminishing, and markets, businesses and consumers may be surprised how quickly the Fed moves once it begins.”,,SB108258824265389952,00.html?mod=COLUMN

What were the 12 month growth rates, 2003:1 to 2004:1?

NGDP “” 6.51% RGDP “” 4.14% GDP deflator – 2.27%

So GDP was growing relatively fast and inflation was above the implicit target but the WSJ was ho hum about raising rates and mentioned the risk of deflation. It seems to me that what the WSJ considers loose monetary policy and high inflation depends on which party controls the White House (Bush of course was facing a tight reelection).