The Fed is (data dependently) on the cusp of attempting to engineer something unprecedented—a relatively benign liftoff of short-term interest rates after an extended period with those rates near their lower bound. Many analysts have been carefully analyzing past tightening episodes hoping to understand the likely Fed behavior, and I am regularly asked what I take as the lessons from, e.g., 2003-2005 and 1994. Here is what history teaches: the FOMC will do what it usually does after 6 years near the lower bound for nominal rates and when its balance sheet is over $4 trillion.
The current situation is far from the range of historical experience, and there will be no simple lessons from history. But there may be more subtle lessons in both the successes and failures of the past. This is the first in a series—not sure how long a series—of posts about unconventional history lessons for the unwinding of unconventional policy.
The most recent example of the Fed engineering anything resembling an unprecedented transition is the Volcker disinflation. After coming into office in 1979 Chair Volcker almost immediately set about a severe tightening of monetary policy that saw inflation fall from over 10 percent to about 5 percent by August of 1982. At that point, the Latin American debt crisis threatened the survival of many large U.S. banks and soon became the focus of policy.
Consider the nitty gritty of how the Fed managed policy. The Fed adopted new operating procedures for the transition, a nonborrowed reserves targeting procedure directed at hitting monetary growth goals stated each year in the form of cones for various measures of money. During the period, each Friday’s announcement of the money supply numbers took on the market-moving importance that is now reserved for nonfarm payroll announcements.
How did this new procedure work out? Inflation came down and has stayed down. Let’s call that success. Volcker is widely, and rightfully in my view, heralded as a hero for his leadership in achieving this objective.
The policy framework, however, was a mess. Because the behavior of the money supply bore no close relation to Volcker and the Fed’s goals, the money supply was redefined several times and the cones were moved mid-year. If we view the monetary cones as the goalposts of policy, the Fed both re-designed the football and moved the goal posts and still didn’t get the ball through the uprights.
The figure below from an article by noted historian Bob Hetzel illustrates this point, and Hetzel’s extended note to the table makes clear several additional machinations:
Hetzel’s note to Table: In order to display the data available contemporaneously, M1 is taken from the first Board of Governors statistical release H.6 showing complete monthly figures for a given year. In 1980, M1-B is used. In 1981, shift-adjusted M1-B is used. This series adjusts other checkable deposits for shifts from nondemand deposit sources. The discontinuity after 1981 arises from the discontinuance of the shift adjustment. After October 1982, the target range for M1 was replaced by a “monitoring” range. The dual ranges for M1 in 1983 reflect the rebasing of the M1 monitoring range in July 1983.
At the time, the Fed was excoriated both by economists and Congress. I was a research assistant at the Kansas City Fed during this period and was tasked with reading all of Volcker’s testimony on monetary policy; being young and naive, I was shocked at the level of discourse. People complain about the tone in Congress today, but the tone of the monetary policy debate was at least as inflamed in the early 1980s.
But few today remember that the Fed’s operating procedure and communications framework were, by any reasonable assessment, a complete hash. Volcker brought down inflation, and missing the cone for M1-b adjusted is relegated to the footnotes of history.
What was the key to Volcker’s success? The key is probably that everyone inside and outside the Fed was pretty clear on the objective the Fed was pursuing: bring down inflation. Everyone could also see that the actual policies followed—regardless of the framework under which they were implemented—were broadly consistent with that prime objective. The rest was sideshow.
For liftoff, I think the lesson is clear. The prime objective will be to make short-term rates go up. Most informed economists agree that the Fed has the tools to do this. That is, some combination of the array of tools available to the Fed can get the job done. And the details? Will the federal funds rate stay near the middle of the announced target range? Will the ranges have to be widened to accomplish this goal? Will the parameters of the overnight reverse repurchase agreement facility have to be adjusted? I don’t know the answers to any of these questions, but if the Volcker case is any indicator, the operational details of implementing this unique transition may at times look quite messy. In the famous modal scenario, however, rates will go up, and the rest will largely be forgotten.
I will admit that I have floated this argument in many circles, and one common refrain is that today is different due to social media, the round-the-clock news coverage, and the hyper-critical Congress. Perhaps these are first-order considerations. Perhaps because of twitter, the Fed must not only achieve the objective, but also achieve it gracefully. If so, we may be doomed.
But I think not. To fill out the modal scenario, the FOMC will emphasize that raising the level of short-term rates is the prime objective and that it has the tools to achieve this. Various adjustments to the particular manipulation of tools will be made, presumably amid a firestorm of blog posts and nasty congressional hearings. And rates will rise, and we will all turn to the next subject.
A note of caution: there are many ways that events in the world could derail this modal scenario, just as the debt crisis replaced disinflation on center stage for Volcker. But that is another subject.
1.Disinflation obviously had many precedents, but this event is probably as close as we can come to unprecedented. In many ways, what is now called the Great Inflation was a unique worldwide phenomenon, and there were certainly unique features to ending it. [back]
2.Robert Hetzel, Monetary policy in the early 1980s. Economic Review, Federal Reserve Bank, March/April 1986. [back]
3.For example, in “A Map for the Road from Dunkirk,” [New York Times, March 21, 1982, as quoted by Hetzel] Nordhaus argued,
The first, step [of a new economic policy] would be to bring down the curtain on the disastrous monetarist experiment of the last two years. The Federal Reserve should be directed to cease and desist its mechanical monetary targeting and to set monetary policy with an eye to inflation and unemployment… At the same time, the Fed should overhaul its operating procedures. The techniques of emphasizing supply of bank reserves rather than interest rates since October 1979 has produced greater volatility of both interest rates and the money supply.
Note to the New York Times headline writers: if I have my history right, a map to the road from Dunkirk was not the issue; perhaps “A chart for sailing from Dunkirk.”[back]
4.With Bryon Higgins (a responsible adult), I threw my naive 2 cents worth in on the topic of redefining money: Bryon Higgins and Jon Faust, NOW’s and Super NOW’s: Implications For Defining and Measuring Money, Economic Review, Federal Reserve Bank of Kansas City, January 1983.[back]