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Economics: It's not just whats' in your wallet

The FED's Policy Dilemma

What is a monetary authority to do when confronted with high inflation rates and a second OPEC price shock? The US economy seemed to be mired in a stagflation trap in the late 1970s - high levels of unemployment and inflation that could be traced to the OPEC decisions to dramatically raise the price of oil in 1973 and 1979. The simple policy prescriptions of the 1960s - a little money here, a little tax increase there and we could keep the economy on the straight and narrow growth track - had failed to effectively solve the stagflation that hit in 1973.

On the domestic front, as the U.S. economy moved into 1979, the unemployment rate had fallen to 5.5 percent from a high of 9.5 percent. Inflation was on the rise again and the second round of OPEC price increases threatened to set off another round of double digit inflation. Real wages continued their fall. Internationally the news was certainly no more comforting as the dollar resumed its slide and the current account deficit in the matter of one year swung from substantial surpluses to deficits. [Diagram 1] The stage was set for either another round of substantial stagflation or a dramatic policy move.

Diagram 1
The Domestic Situation

The International Situation

So what was the Fed to do? There was a real problem - what we might call a dilemma. And once again we can see the problem with a simple graph - or maybe a few.

First the situation. The increase in the price level will drive up demand for money - if you are paying higher prices you will need to carry more money to pay your bills. The increase in money demand would put upward pressure on interest rates (i* to i**) and on the money supply (M* to M**).

Diagram 2

The Fed needed to respond to the upward shift in the money demand curve - and there were only two choices - either the Fed could adopt a policy targeting interest rates, or one targeting the money supply.  What it could not do is simultaneously hit a money supply (quantity) target and an interest rate target (price).  For example, if the Fed wanted to keep interest rates from rising as a result of the increase in money demand, then it would need to change the money supply in such a way as to relieve the upward pressure on interest rates.  The Fed could return rates back to their original level if they increased the supply of money. The impact of the increase in the supply of money can be seen in the left-side of Diagram 3.  In this situation the Fed would undertake policies to increase the money supply (outward shift in the supply curve). This would bring interest rates back to their initial level (i*). To reestablish the original interest rate, the money supply would increase from M* to M**.  By targeting the interest rate the Fed had to give up control of the money supply since money supply increased as the Fed hit its interest rate target.

A second option for the Fed would be polices to target the money supply. In the face of increased demand that put upward pressure on the money supply, the Fed would respond with policies aimed at reducing the money supply - an inward shift in the money supply curve in the right-side diagram. The result would be a constant money supply (M*) and a higher interest rate.

Diagram 3
Alternative Fed Strategies

What should be clear is that the policies could be expected to have substantially different effects on the economy. But which policy route to take? The advice from the theorists was, as you would expect, mixed. It was a difference that could be traced to fundamentally different views of money's role in the economy.

On the one side we had the Keynesians who believed that interest rates mattered and an easy money policy (increase in money supply) would be in order keep the economy from falling into another OPEC induced recession. On the other side we had the monetarists - the modern day Classical economists who accepted the Quantity Theory of Money and its Equation of Exchange which linked the money supply with the price level. According to the monetarists, the Fed should adopt a tight money policy to slow the growth in the money supply which would allow the US to avoid another round of inflation. The basis for their view is captured in the dynamic version of the Equation of Exchange which linked the inflation rate (p) directly to the growth rate in the money supply (m).

m = y + p - v

Some economists were even arguing for adoption of a monetary rule - essentially replacing discretionary monetary policy with a simple formula derived from the above relationship. By plugging in the growth rate in potential output (y) and velocity (v), the Fed would need to set the growth rate in the money supply at a rate that would achieve the desired inflation rate. For example, if the Fed had a goal of 0 inflation and expected the economy to grow at 2 percent per year, and velocity to remain constant, then it should undertake policies designed to keep money supply growth at 2 percent [ 2 = 2 + 0 - 0). In essence we would replace the Fed with a computer programmed to meet the target levels for the money supply growth.

In the 1970s the Fed was following policies that were generally Keynesian, but there was a dramatic policy reversal announced on October 6, 1979.  At that time the Fed's chairman Paul Volcker announced the Fed was changing the focus of its policies. Prior to the announcement, the Fed, under the influence of Keynesian economists, was far more concerned with targeting interest rates and trying to keep them low to get the economy growing.  According to Volcker and the monetarists, however, there was a fundamental flaw in the accommodating monetary policies adopted by the Fed.  The flaw was the inability of the Fed's policy officials to make the distinction between real and nominal interest rates.

The relationship between the the real interest rate (r_r), which is what we believe affects decision makers and should be the concern for policy officials, the nominal interest rate (r_n), which is the rate we actually see reported in the financial press, and the expected inflation rate (i_e) is given by the equation:

r_r = r_n - i_e

In normal times the inflation rate remained rather stable and information on the real rate of interest, what matters to the Keynesians, could be used to determine what was happening to nominal interest rates.  By 1974 inflation rates had risen above the rate on short-term government securities and remained there through the end of the 1970s so real rates were actually negative. By 1979 it was beginning to look like an inflationary spiral as G. William Miller's program of gradualism poured money into the system to moderate interest rate increases.  The result of the money supply increases would be an increase in inflation which would push nominal rates even higher.

Diagram 4

The policy of monitoring interest rates came to an end on October 6, 1979 when recently elected FED chairman Paul Volcker returned home early from an IMF meeting in Belgrade to announce the FED would redirect its efforts toward hitting its monetary targets and let interest rates seek their own level. The Keynesian experiment with pegging interest rates was over - or at least it seemed so at that time - and the Fed would now establish money supply targets and hit them.  The "beauty" of this change in approach was the Fed could now allow interest rates to rise to indefensible levels impossible if policies were focused on interest rates.  

The FED was clearly successful at lowering the growth rate of the money supply and interest rates did respond. By 1981 nominal rates had peaked, real rates on short-term government securities had risen substantially and were above their post WW II average, and the volatility in rates was up sharply.

Diagram 5

As it turned out, the experiment was called off in 1982. The inflation spiral appeared to have been broken, but the cost was substantial as the US entered its most serious slowdown since the Depression. More importantly for the Monetarists who supported this approach, Carter's imposition of credit controls in 1979 and passage of the Depository Institutions Deregulation and Monetary Control Act of 1980 seriously weakened the value of the monetary aggregates as policy instruments. The move toward "rules" had been reversed and the FED was once again monitoring interest rates.

It's now time to move into the 1980s, where will shift our attention back to fiscal policy and examine the set of policies that became known as Reaganomics or Supply-side economics and the theory of economic growth.

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