Speech

Inflation, Recession, and Fed Policy MidwestEconomicEducationConference St.Louis,Missouri April11,2002 There is a conventional wisdom still ploymentbecauseinflationtendedtohobbleFed abroad in both the academic and jour- responsetoeconomicweakness.Incontrast,last nalistic worlds that the economy faces yeartheFedcouldrespondaggressivelytodevel- anunpleasanttradeoffbetweeninflation opingeconomicweaknesswithoutconcernthat andunemployment.Intheacademicworld,most doingsowouldincreaseinflationexpectations. economists qualify the proposition by noting Bymaintainingcontinuouslylowandstable that there is no long-run tradeoff, but they also inflationtheFedputsitselfinastrongposition often point to a short-run tradeoff. tocountermanysortsofdisturbances,suchasthe I’llnotdiscussthetradeoffissuedirectly upsetinfinancialmarketsin1998,developing tonight,butinsteadwanttoconcentrateonthe economicweaknessoverthecourseoflastyear relatedissueofhowFedmonetarypolicyis andtheterroristattacksofSeptember11.Low affectedbytheexistence,orlackthereof,ofinfla- inflationisnotonlyconsistentwithhighemploy- tion.Considerthefollowingobservation,which mentonaverage,butalsohelpstostabilize Ithinkisquiteremarkable.Oftheninerecessions employmentinthefaceofnegativeshocksthat sincetheKoreanWar,theonlyoneinwhichthe couldhaveseriousemploymentrepercussions. FederalReservecutthediscountratebeforethe Lowinflationisstabilizingbecauseitreduces recessionbegan,orevenwithinseveralmonths expectationalerrorsintheprivatesectorand ofthebusinesscyclepeak,wasthecyclepeak becauseitpermitsanaggressiveFedpolicy inMarch2001.I’musingthediscountrateasa responsetorecessionorthreatofrecession. measureofFedpolicybecausebefore1994the Beforeproceeding,Iwanttoemphasizethat discountratewastheprimemethodtheFed theviewsIexpressherearemineanddonot usedtomakeapublicannouncementofapolicy necessarilyreflectofficialpositionsoftheFederal change.Since1994,whentheFOMCfirstbegan ReserveSystem.Ithankmycolleaguesatthe toreleaseitspolicydecisionattheconclusionof FederalReserveBankofSt.Louis,especially itsmeeting,changesinthefederalfundsratepro- CharlesHokayem,fortheirassistanceandcom- videdthepublicannouncementofpolicychanges. ments,butIretainfullresponsibilityforerrors. However,after1994thediscountratecanstillbe usedasanindicatorofpolicychangebecause adjustmentsinthediscountrateandfederalfunds THE PHILLIPS CURVE ratehaveoccurredtogether. FRAMEWORK ThethemeI’llexploretonightisthathistori- callytheFed’srelativelyslowpolicyresponseto Thestandardframeworkforrelatinginflation adevelopingrecessionwasadirectconsequence, andunemploymentistheinflation-expectations inmostcases,ofitsconcernthatitnotsignala augmentedPhillipsequation.Somemeasureof policychangethatmightraiseinflationexpecta- inflationisontheleft-handsideoftheequation; tions.Thusinflation,oritsthreat,hashadan theright-handsidecontainstheexpectedrateof indirectshort-runeffecttendingtoincreaseunem- inflationandagapterm.Someresearchersspec- 1 ECONOMICFLUCTUATIONS ifythegapasthedifferencebetweentheequilib- mycasebyquotingpassagesfromtheminutesof riumandactualratesofunemployment;others FOMCmeetingsatthetimeofcyclepeaks.Forthe usethegapbetweenactualandhigh-employment earliermeetings,theminutesreallyareminutes realGDP.Whentheunemploymentrateisused, inthetraditionalsense.ThepassagesI’llquote someliketocalltheequilibriumratethe“natural arefromwhatiscalledthe“Memorandumof rate”andsomeliketocallitthe“non-accelerating Discussion.”Forthelatermeetings,thepassages inflationrateofunemployment”or“NAIRU.” arefromthemeetingtranscript,whichisalightly Asanaside,Iwanttoemphasizethatthe editedversionoftheverbatimtranscriptfrom Phillipsequationshouldnotnecessarilybeviewed thetaperecordingoftheFOMCmeeting. asacausalrelationship.Inflationandthegapare jointlydeterminedinalargermodel;placingthe inflationrateontheleft-handsideoftheequation FED POLICY AT THE ONSET OF doesnotsettletheissueastowhetherthegap RECESSIONS causesinflation.I’mnotgoingtoenterthatdebate Hindsightisalwayseasy.Atthetimepolicy here,butraisetheissuebecauseIdonotwantto decisionsaremade,nooneknowsthatabusiness leavetheimpressioninadvertentlythatIbelieve cyclepeakisathand.Atbest,theremaybesome thatthegapcausesinflation. signsofaslowingeconomy,butsuchsignsare Itisinteresting,Ithink,thatmostoftheliter- oftensimilartowhatlaterturnouttobepauses atureonthePhillipsrelationconcentrateson incontinuingexpansions.Sometimessignsofa measuringtheequilibriumrateofunemployment, slowingeconomyareerasedbydatarevisions. orthecorrespondingfull-employmentlevelof Followingthedataandeconomicpolicyasclosely GDP,andtherelationshipofinflationtothegap asIhaveformanyyearsleavesmewithahealthy term.Issuesoflags,oftheeffectsofdemographic respectforhoweasyitistobewrong.Keepthese changeontheNAIRU,ofproductivitygrowth, commentsinmindasIreportveryselectivelya andonandonfillthepagesofprofessionaljour- fewfactsaroundbusinesscyclepeaks—peaks nals.Veryfewpagesaredevotedtotheinflation thatanyoneofuscanpickouteasilytodayfrom expectationsterm. therecordpublishedbytheNationalBureauof Therationalexpectationsmacroliterature EconomicResearchbutwhichwereunknownto emphasizesthatallinformationrelevanttothe thepolicymakerswhentheywerereachingtheir formationofexpectationsneedstobeincorpo- policydecisions. ratedinasatisfactorymacromodel.Thatinfor- mationcertainlyincludesexpectationsconcerning thefuturecourseofmonetarypolicy.Thisideais Cycle Peak of July 1953 generallyacceptedtodaybymacroeconomists Overthe12monthsendingwiththecycle andcertainlybypolicymakers.Yet,incorporating peakofJuly1953,theCPIroseby0.4percent. theideaempiricallyinthedeterminationofthe Althoughinflationwasnotaproblem,everyone inflationexpectationsterminthePhillipsrelation rememberedtheKoreanWarinflation,whichhad hasnotgoneveryfar. runinexcessof9percentona12-monthbasisin I’mgoingtotrytoconvinceyouthatFed early1951.TheminutesoftheFOMCmeetingof concernsaboutinflationexpectationshavebeen June23,1953reportthat,“Mr.[Allan]Sproul extremelyimportantintheneighborhoodof [PresidentoftheFederalReserveBankofNew mostbusinesscyclepeakssincetheKoreanWar. YorkandViceChairmanoftheFOMC]questioned I’llnottakeapositiononwhetherthoseconcerns whether[alargeTreasuryfinancing]wasdesir- wereorwerenotfullyjustifiedatparticular able,andsaidthatsuchactionwouldmagnify, times—Ijustwanttoarguethattheconcerns perhapsunnecessarily,theproblemofproviding werethereandaffectedFedpolicy.I’lldocument reserves…atthistimewhentheSystemwasstill 2 Inflation,Recession,andFedPolicy tryingtowalkthetightropebetweeninflationary kindleagaintheinflationaryexpectationsthat anddeflationarydevelopments.” haveheretoforedonethecountrysomuchinjury; butwemustsupplythereservesnecessaryto Cycle Peak of August 1957 permitasustainablegrowthintheeconomy.” Overthe12monthsendingwiththecycle Cycle Peak of December 1969 peakofAugust1957,theCPIroseby3.7percent. Inflationwasanactiveconcern,giventhatthe Overthe12monthsendingwiththecycle inflationratehadbeenslightlynegativein1955. peakofDecember1969,theCPIroseby5.9per- TheFedactuallyincreasedthediscountratein cent.ThiswastheeraoftheVietnamWarinflation, thecyclepeakmonth;thefirstreductioncame andinflationconcernsranhigh.TheFedhad November1957,threemonthsafterthecyclepeak. increasedthediscountrateinApril1969;the FOMCmeetingsduringthesummerandfall firstcutcameinNovember1970,elevenmonths of1957werefullofconcernaboutinflation. afterthecyclepeak. AccordingtotheminutesofthemeetingofJuly30, InthemeetingofNovember25,1969,the 1957,“[GovernorCharles]Shephardsonexpressed minutesreportthatAlfredHayes,presidentof concernabouttheapparentlywidespreadextent theFederalReserveBankofNewYorkandVice ofthefeelingthatfurtherinflationwasinevitable. ChairmanoftheFOMC,hadtheseviews:“With Herecalledthatatthelasttwomeetingsofthe respecttopolicy,Ifeelthatpresentcircumstances Committeehewasverymuchinfavorofmoving clearlycallfornochangeintheexistingdegree furtherinthedirectionofrestraint.Atpresenthe ofrestraint.Thereisstillwidespreadskepti- didnotthinkthatthesituationwassubstantially cismthattheSystemwillpersevereintheanti- different.” inflationarybattle,andIcanseelargerisksinany Accordingtotheminutesofthemeetingof generalpolicyrelaxationthatcouldgiveasignal September10,1957,“Chairman[Martin]went fornewinflationaryactivities.”Inthemeeting ontosaythathedidnotthinktheproblemof ofJanuary15,1970,GovernorDeweyDaane inflationhadbeenlickedandhedoubtedthat “remarkedthathepreferredtostaywithinthe thiswouldoccuruntiltherehadbeenamodest frameworkofalternativeAbecausehewaswor- correctionofpastexcesses.Hedidnotknowwhen riedabouttheriskofreinforcinginflationary suchacorrectionwouldcome,buttherehad expectations.Suchexpectationswerelikelyto beenmanyexcessesinthecourseofthepast18 bestimulatedfurtherifadramaticmove,involv- monthsandadjustmentswouldhavetobemade ingbothincreasesininterestrateceilingsandan atsomepoint.” easingofopenmarketpolicy,weretakenbythe Systemnow.”Thetensionbetweenaddingto Cycle Peak of April 1960 inflationarypressuresandresistingincreasesin unemploymentcontinuedmeetingaftermeeting Overthe12monthsendingwiththecycle untilwage-pricecontrolswereimposedin peakofApril1960,theCPIroseby1.7percent. August1971. Inflationwasnotofgreatconcern,buthereagain thememoryoftheinflationof1957,whichcon- Cycle Peak of November 1973 tinuedwellinto1958evenastherecessiondeep- ened,wasfresh.Thefirstcutinthediscountrate Overthe12monthsendingwiththecycle cameinJune1960.TheminutesoftheFOMC peakofNovember1973,theCPIroseby8.3per- meetingofMay30,1960,reportthatMalcolm cent.Wage-pricecontrols,whichhadseemedto Bryan,PresidentoftheFederalReserveBankof suppressinflationforatimein1972,hadbroken Atlanta,saidthis:“Myownconclusionisthus down.In1973,theFedincreasedthediscount thatwe[theFOMC]canjustifyapolicythatkeeps rateinJanuary,February,twiceinMay,June,July, bankcreditexpansionundercontrol,lestwe andAugust.TheFedincreasedtherateagainin 3 ECONOMICFLUCTUATIONS April1974.ThefirstcutcameinDecember1974, danger,andmaybeanoverridingdanger,of thirteenmonthsafterthecyclepeak. underkillratherthanoverkill… MinutesofthemeetingofDecember18,1973 Itwouldbelovelytosteerthoseinterestrates reportChairmanBurnsassayingthat“thetask downifweknewhowtosteerthem,whichIdon’t ofmonetarypolicycouldnotbethesameasin thinkwedo.Butifwedid,whataretherisksthat aclassicalrecession.Thecontinuanceofsharp inafewmonthswewill[witness]anotherrebound inflationclearlyrequiredcautionandsome intheeconomyandHenryKaufman’s[unintelli- restraintincarryingoutapolicyofmonetary gible]scenariowillcometrue?Thenwewillbein easing.” anevenmoredifficultperiod,losingtimeatthe veryleastinthefundamentalfightoninflation; Cycle Peak of January 1980 andwewill[face]amoreawkwardmarketandI supposea[worse]politicalsituationnotverymany Overthe12monthsendingwiththecycle monthsdowntheroad,withhigherinterestrates, peakofJanuary1980,theCPIroseby13.9percent. moreconcernaboutfinancialinstitutions,bank- Energywasnotthewholestory;theCPIlessfood ruptcies,theoutlookfortheeconomy,andall andenergy—thecoreCPI—wasupby12.0percent therest.” overthesame12months.TheFedincreasedthe discountrateinFebruary1980;thefirstratecut Cycle Peak of July 1990 cameinMay. TheMarch1980FederalReserveBulletin Overthe12monthsendingwiththecyclepeak ofJuly1990,theCPIroseby4.8percent.Thefirst reportedontheFOMCmeetingofJanuary8-9, discountratecutcameinDecember,sixmonths 1980.Thisreportnotedthat“concernwas afterthecyclepeak.Iraq’sinvasionofKuwaitin expressedthatanysubstantialdeclinesininterest Augusthadsentenergypricessoaring,butthat ratesmightbeinterpretedasasignificanteasing wasnotthewholestory.CoreCPIinflationhad ofmonetarypolicyandthuscouldhaveadverse beencreepingup,from4percentorabitlessin consequencesforinflationaryexpectationsand 1986to5percentatthecyclepeakbeforetheinva- fortheforeignexchangevalueofthedollar.” sion.Aftertheinvasion,CPIinflationreached about6½percentona12-monthbasisandcore Cycle Peak of July 1981 CPIinflationabout5½percent.Ashadhappened Overthe12monthsendingwiththecycle sooftenbefore,theFedwasinsomethingofa peakofJuly1981,theCPIroseby10.8percent; bindbecauseeasingpolicyaggressivelytoresist thecoreCPIwasupby11.1percent.TheFedhad therecessionmighthavecreatedfearsofeven increasedthediscountrateinMay1981;thefirst higherinflation. cutcameinNovember.Aftersomanyfalsestarts Thebackgroundofinflationconcernswas indealingwithinflation,bythistimetheFedwas evidentwellbeforethecyclepeak.Theminutes inaverydifficultposition. oftheFOMCmeetingofMay15,1990,report TheminutesoftheFOMCmeetingof ChairmanGreenspanassaying,“Nonetheless,I August18,1981,reportChairmanVolckeras dothinkthattheinflationproblemisverytrouble- saying:“Giventhatweareintheearlystages,if some.AndwhileIwouldfeelcomfortablewith Icanputitthatway,ofanysuccessintheanti- ‘B’eithersymmetricorasymmetric,ImustsayI inflationaryeffort—giventhatkindofoutlook wouldprefersymmetricandwouldhavethe andgiventhedemonstratedapparentresilience policyrecordrelatetheconcernsthathavebeen oftheeconomyinthefaceofveryhighinterest expressedaroundthistableontheissuesofinfla- ratesdespitethedistortionsintheeconomyand tionandtheinstabilitiesthattheycreate.But,like theverydifferentimpactsondifferentsectors— thelasttime,Ithinkit’satoughcall,andIsuspect itseemstomethatthereisstillaconsiderable itmaybenolesseasyaswegetfurtheroninto 4 Inflation,Recession,andFedPolicy theyear.So,mybottomlineatthismomentis volumeofadjustmentcreditlentbytheFedto ‘B’symmetric,butwithextensivelanguagein depositoryinstitutionsthroughthediscount thepolicyrecordontheissueofinflation.” windowroseto$45.5billion,upfrom$99million BytheFOMCmeetingofDecember18,1990, theWednesdaybefore.AlsobyWednesday, theFedhadstartedtheeasingprocess,butwas September12,floathadrisento$22.9billion,up stillconcernedaboutinflation.Atthatmeeting, from$2.1billionthepreviousWednesday.The ChairmanGreenspansaid:“Atsomepointweare OpenMarketDeskattheNewYorkFed,itself goingtocomeoutofthisandwewanttomake operatingfromacontingencysitebecauseits reasonablycertainthatwhenwedowe’renot officeneartheWorldTradeCenterwasclosed, lookingatadegreeofliquidityinthesystemthat wasabletopurchasealargevolumeofsecurities bringswithit[higher]inflationratesandthenext throughacombinationofoutrightpurchasesand downturnmuchmorequicklythanisusual.” temporarypurchasesunderrepurchaseagree- ments.Moreover,theFedarrangedcurrencyswap Cycle Peak of March 2001 agreementswithseveralforeigncentralbanks, whichenabledthemtoprovidedollarstotheir Overthe12monthsendingwiththecycle financialinstitutions. peakofMarch2001,theCPIroseby3.0percent; Allthesemechanismstakentogether thecoreCPIinflationratewas2.7percent.The expandedFederalReservecreditby$90billion, firstdiscountratecutcameinearlyJanuary,two orabout15percent,betweenWednesday, monthsbeforethecyclepeak.TheFedcutrates September5andWednesday,September12.At aggressivelythroughouttheyear,withoutconcern nopointdidtheFedormarketparticipantsfear thatdoingsowouldrekindleinflationorfearsof thatallthisliquiditywouldcauseaninflation inflation. explosion.Asthefinancialsystemrestorednormal TranscriptsofFOMCmeetingsin2001will paymentsmechanisms,andsecuritiesmarkets notbereleasedforanotherfouryears.However, reopened,theextraliquidityflowedbacktothe thepublishedminutes,whichdonotattribute FederalReserve.Loansatthediscountwindow particularviewstoparticularcommitteemembers, wererepaid,floatdeclinedascheckscleared, areavailable.MinutesoftheJanuary3,2001 andOpenMarketDeskpurchasesofsecurities FOMCmeeting,whichwasheldbyconference underrepurchaseagreementexpired.Withina call,notethat:“Inflationexpectationsappeared fewweeks,thesystemwasfunctioningcompletely tobedeclining,withbusinessescontinuingto normallyonceagain. encountermarkedandevenincreasedresistance totheireffortstoraiseprices.Onbalance,the informationalreadyinhandindicatedthatthe DISCUSSION expansionclearlywasweakeningandbymore thanhadbeenanticipated.Inthecircumstances, Macroeconomistsacrossthespectrumof promptandforcefulpolicyactionsoonerand beliefsagreethatonlythecentralbankcanachieve largerthanexpectedbyfinancialmarketsseemed pricestability.Thatis,ifthecentralbankdoes calledfor.” notfollowappropriatepolicies,nootheragency Perhapsthemostdramaticevidenceofthe ofgovernmentandnoactionsbyprivateparties payofffromentrenchedexpectationsoflowinfla- canachievethatgoal.Acentralbankthatfailsin tionwasthefreedomtheFedhadtorespondto thatmissionwillraisejustifiableconcernsinthe theterroristattacksofSeptember11.Idiscussed marketsthatthefailuremightcontinueandpos- theFed’sroleindealingwiththecrisisina siblyworsen.Thetimetodealwithinflationis speechlastOctober.Inbrief,theFedprovided beforeithappens.Allowinginflationtodriftup extraliquiditytothemarketsinavarietyofways. createsaneconomicvulnerabilitybecauseinfla- OnWednesday,September12,theoutstanding tionexpectationsmaybegintodevelopjustasthe 5 ECONOMICFLUCTUATIONS upwardthrustofeconomicgrowthfalters.Given inflationconcerns,thecentralbankisthenina difficultposition.Easingpolicywhengrowth falters,orappearstofalter,maystokeinflation fearsincreasingthedifficultyandcostofbringing inflationundercontrol. Contrarytothinkingintradeoffmodels,where weareaskedtoanalyzethesocialcostofinflation asopposedtounemployment,Iamconvinced thatsustainedpricestabilitycreatesthebest environmentforlong-runhighemploymentand reducedriskofrecession-inducedincreasesin unemployment.Wheninflationislow,theFed canresistrecessionthroughaggressiveratecuts inawayitsimplycannotwheninflationisan issueinthemarkets.Bykeepinginflationcontinu- ouslylow,theFedgainsthefreedomtorespond asnecessarytotheinevitablesurprisesandshocks thathittheeconomy. Ihopethatmyreviewofexperienceinthe neighborhoodofcyclepeakswill,ifnotconvince youofthevalidityofmyposition,atleastencour- ageyoutostudytherecordindetailyourself.I amnottryingtosaythatlowinflationistheonly criterionforsuccessfulmonetarypolicy;however, Iamconvincedthatlowinflationisanindispen- sableingredienttoprovidingroomformonetary policyadjustmentsrequiredtokeeptheeconomy onasstableagrowthpathaspossible. 6

William Poole (2002, April 10). Speech. Speeches, Federal Reserve. https://whenthefedspeaks.com/doc/speech_20020411_poole

@misc{wtfs_speech_20020411_poole,
  author = {William Poole},
  title = {Speech},
  year = {2002},
  month = {Apr},
  howpublished = {Speeches, Federal Reserve},
  url = {https://whenthefedspeaks.com/doc/speech_20020411_poole},
  note = {Retrieved via When the Fed Speaks corpus}
}