Why a good “policy stance” might matter

I haven’t read John Taylor’s newest working paper yet, but its about the Fed’s start-stop policy stance under the ancien régime. The story he’s riffing on in that paper is pretty standard. There was high and variable inflation under the old monetary policy regime because the Fed didn’t fully accept its role in determining inflation. It would have moments of commitment to fighting unemployment or the output gap and so it would loosen policy. When inflation came, they’d commit to lowering inflation. They’d tighten policy long enough to induce a contraction in output, but not long enough to re-anchor inflation expectations at lower rates. Rinse and repeat. Stagflation and uncertainty.

Then Volker came and saved the day!
gdp

The Great Inflation is the time before 1985 and the Great Moderation is the time after. I’ve labeled the regime average and standard deviations.

I’m not interested in debating the reasons for the Great Moderation starting in the mid-80s, but at least one reason for the decrease in volatility in both output and inflation is that the policy stance of the Fed changed. It gained credibility as an inflation stabilizer. It was going to set an (implicit) inflation target and do what it needed to hit it.

Compare the 25 years before 1985 to the 25 years after. The old regime saw 5 recession, the new regime only three (and two of those were pretty mild). As you can see in the graph (which includes the most recent recession), volatility of output decreased. Similarly, volatility of inflation and consumption also decreased. As Bernanke pointed out in his Great Moderation speech, these trends are evident in other countries as well.

The thing that changed was the adoption of a confident and credible policy stance by Central Banks around the world. They woke up to their power to control inflation. And Bernanke was trying to wake up the Bank of Japan to its power as an effective manipulator of inflation; to build their confidence. Central Banks also learned the power of credibility. And this is why Bernanke responded to Delong’s question the way he did.

8 Responses to “Why a good “policy stance” might matter”

  • Post-’80s is better than pre-’80s, but that’s “good” only relative to “crappy”.

    I don’t know if we can do better than what was practiced during the ’90s but I’d like to know.

  • pushmedia1 says:

    The AC comment I was expecting was “who cares! look how much technocratic interference we have to have to marginally lower volatility! from a welfare point of view, this is just a tempest in a teapot!”

  • ssendam says:

    Reminds me of this: http://artsci.wustl.edu/~morley/great_moderation.pdf
    Was it caused by better central bank policies? Or structural changes in the economy (e.g. globalization keeps upward wage and price pressures in check), or maybe firms have simply gotten better at managing their inventories? Or maybe it’s just luck. Haven’t seen much exploration of the other views, which might be due to the limitations of aggregate data, or maybe because economists are already predisposed to view the Fed as all-powerful.

  • pushmedia1 says:

    Also, a paper about all this being caused by luck would be short and boring. Papers on structural changes are relatively common, though.

  • Scott Sumner says:

    Delong asked Bernanke why the Fed doesn’t set an explicit inflation target. Bernanke said that would destroy credibility. How does that answer the question? That implies the Fed is happy with the current and future expecte level of AD. But when the Fed asked Congress to do massive fiscal stimulus, was that consistent with inflation targeting? How about when the Fed let prices fall after September 2008? I don’t see how the Fed has any credibility, unless its only goal is not to allow high inflation. I think they will succeed in that goal, but surely inflation targeting should be symmetrical.

  • pushmedia1 says:

    He was not asked about an explicit target, just a target. Delong: “Why haven’t you adopted a 3% per year inflation target?”

    Bernanke wasn’t answering a question about an explicit target. He was answering a question about increasing the implicit target. Bernanke: “The public’s understanding of the Federal Reserve’s commitment to price stability helps to anchor inflation expectations… The Federal Reserve has not followed the suggestion of some that it pursue a monetary policy strategy aimed at pushing up longer-run inflation expectations.”

  • Push, movements over the cycle are peanuts, or they would be if we had good social insurance. Conditional of not having it, I’m a believer in the social ills of unemployment and such.

    I think we tend to overestimate the smarts of the post-’80s Fed guys and underestimate the pre-’80s peeps. For a different interpretation, I like Sargent: http://press.princeton.edu/titles/6635.html The Fed was learning, it was changing, it was… mutating!

  • AC and Push,

    I like Sargent’s story, but I am not sure that it fits with what was going on the Fed at the time. I would recommend Nelson:

    http://www.bepress.com/bejm/advances/vol5/iss1/art3/