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.

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.

It’s not structural, and it wouldn’t matter if it was (pt. 2 of 2)

It didn’t take Andy Harless long to figure out what part 2 of this essay would look like.  Here’s his comment to part 1:

At the risk of giving away the punch line: structural unemployment is pretty much the same deal as an oil shock; it’s a reduction in aggregate supply. In both cases, employment eventually readjusts: in the structural case, because workers get retrained, relocated, &c; in the oil shock case, because product prices and productivity rise faster than wages so as to re-establish profit margins. In both cases, the adjustment happens faster if monetary policy accommodates: because there is more incentive to retrain and relocate workers; or because product prices rise more quickly.

The bottom line is that the Fed had been delivering 5% NGDP growth for decades, and no matter what caused the current crisis, they needed to continue delivering 5% NGDP growth.  This means that money has been far too tight since August 2008, even if most of the unemployment is structural.  I am reacting to statements like this from Narayana Kocherlakota:

Monetary stimulus has provided conditions so that manufacturing plants want to hire new workers. But the Fed does not have a means to transform construction workers into manufacturing workers.

There are so many things wrong with this that I hardly know where to begin:

1.  The structural theory is usually based on the fact that the housing bubble caused residential housing to become severely overbuilt by 2006, necessitating a sharp decline in construction jobs regardless of what the Fed did.  That’s true, but as this graph shows, almost all the decline in housing occurred BEFORE the severe phase of the recession started in August 2008.  (Almost halfway through the blue vertical band that starts in December 2007.)  So there was a structural loss of jobs after mid-2006, but it has little to do with the sharp rise in unemployment that only began two years ago.

2.  The sharp loss of jobs that did begin in August 2008 was associated with three areas mostly unrelated to sub-prime housing; manufacturing, commercial construction, and services.  All three of these turned down sharply precisely when NGDP started falling, i.e. when money got ultra-tight.

3.  The problem is not struggling with the re-allocation of construction workers into manufacturing, as manufacturing has also shed lots of jobs.

4.  It’s really not that hard to transform construction workers into factory workers.  For God’s sake in WWII we put housewives into factories!  And the average construction worker is far more skilled with heavy machines than the average housewife.

5.  The Fed has not provided the monetary stimulus required so that factories want to hire workers.  Volcker provided the monetary stimulus for factories to want to hire workers when he engineered 11% NGDP growth at an annual rate for the first 6 quarters of recovery in 1983-84.  We’ve been running 4% NGDP growth in the first 4 quarters, and we are now downshifting to 3%.  How can you get the 7.7% RGDP growth of the earlier recovery if NGDP is growing 3%?  Are we going to have a minus 4.7% GDP deflator?  When has an economy ever boomed with 5% deflation?  People who ask why the economy should not yet have adjusted to 1% inflation are asking completely the wrong question.  Even if we had adjusted, it would take 8.7% NGDP growth to get a Volcker-esque recovery.  It’s simple math.  What you are really asking is why isn’t inflation falling even further.  That’s a tougher question.  The 40% jump in minimum wages, and the 99 week unemployment extension probably made labor markets a bit less flexible that usual.  But overall what we are seeing is not that far out of the normal.  Both real GDP and inflation fell, with RGDP falling more sharply.  That’s pretty normal for steep recessions.

Now let’s return to Andy’s point.  Almost everyone agrees that the SRAS is upward sloping, even my critics.  After all, my critics claim the Fed blew up the housing bubble with easy money in 2003, and that can only occur if money is non-neutral.  This means that even if 100% of the current unemployment problem is structural, it is still true that monetary stimulus will boost employment.  And since inflation is still below target, and expected to remain below target, monetary stimulus would also improve the inflation situation.  It’s a win-win.  So when people say that structural problems argue against monetary stimulus, they aren’t just wrong, they are doubly wrong.

Part 2:  Stop searching for the Holy Grail of macro

Since David Hume, every bright young economist seems to want to take a stab at the problem of why nominal shocks have real effects (i.e. why the SRAS slopes upward.)  They’ve all failed.  It’s not that they haven’t come up with explanations; they’ve come up with plenty.  Bennett McCallum once listed ten versions of price stickiness.  Then there is wage stickiness.  And misperceptions.  And money illusion.  And that’s ignoring how the supply-side intersects with nominal shocks, as when governments extend UI to 99 weeks during recessions.

They sift through all sorts of micro-level data, develop macro stylized facts, and then try to connect them up with theory.  But they never get anywhere.  Maybe all theories are true to some extent, and the relative importance of each effect varies from one business cycle to another.  Milton Friedman once said that in 200 years we’ve only gone one derivative beyond Hume.  (We look at changes in inflation, rather than changes in the price level.)

So I get pretty discouraged when I read economists trying to sift through micro-level data about prices and labor markets, searching for the Holy Grail of the micro-foundations of recessions.  Hume explained our recession 200 years ago:

“If the coin be locked up in chests, it is the same thing with regard to prices, as if it were annihilated.” David Hume “” Of Money

That’s right; Hume knew that if the Fed paid interest on bank reserves, encouraging them to lock up excess reserves, it was like a contractionary monetary policy.  Fed presidents would be better off spending more time reading Hume, and less time sifting through micro data that supposedly disproves “the” Keynesian model (as if there’s only one!)  The brightest minds of the profession have attacked the problem for 200 years, and they’ve all failed.  It’s a black box.  It is truly the Holy Grail of macroeconomics.

Please stop searching for structural patterns, and start boosting NGDP growth.

(PS:  I do agree that Obama’s economic policies are considerably less pro-growth than Reagan’s, but we could still be doing much better than we are.  “There’s a great deal of ruin in a nation.”  And again, those policies do not excuse the Fed allowing NGDP to suddenly fall 8% below trend.)