Monetary Policy Lessons of Recent Inflation and Disinflation

This 1988 Journal of Economic Perspectives paper by William Poole is a survey and analytical essay – not a structural estimation exercise with a formal identification strategy – that draws lessons from the U.S. inflation and disinflation experience of roughly 1975 to 1987 for money demand, real interest rate behavior, market expectations of monetary policy, and the design of monetary rules. Its central empirical exhibit is the breakdown of the “standard” M1 demand function: a specification with income elasticity near 1.0 and interest elasticity of only about 0.15 to 0.25 (citing Goldfeld 1973) had appeared consistent with a roughly 3 percent per year secular rise in M1 velocity from 1953:1 through 1979:4, but velocity departed sharply and unpredictably from that trend after 1981. Poole argues the conventionally low interest elasticity is itself an artifact of estimating money demand in first-difference form: annual first-difference regressions of the change in log(M1 velocity) on the change in log(Aaa bond yield) over several sub-periods between 1916 and 1986 (Table 2) yield coefficients of only about 0.07 to 0.28 (and the wrong sign, -0.16, for 1919-1946), because a constant term in a first-difference regression is mathematically equivalent to a linear time trend in levels and so absorbs the velocity trend that the trending interest rate should instead be explaining, and because short-run money-demand “disturbances” are in fact correlated with credit-market and income disturbances (a “buffer stock” mechanism) rather than statistically independent as the standard specification assumes. Re-estimating in levels, with income elasticity constrained to 1.0 and using sample periods chosen so the interest rate is approximately the same at both endpoints to limit trend-attribution bias (1915-1964 and 1920-1968), Poole obtains – and explicitly calls “tentative” – an interest elasticity of about 0.6 in absolute value (Table 3), two to four times the first-difference estimates, with the long-term Aaa bond yield fitting consistently better than the commercial paper rate (coefficients of roughly 0.65-0.67 versus 0.19-0.33, with higher R-squared throughout), which he attributes to agents responding to permanent rather than transitory changes in the opportunity cost of holding money. On real interest rates, Poole notes they rose from roughly 1-2 percent (1953-73) and 0 to -2 percent (1973-78) into a 4-8 percent range in 1980-85, and argues that while the severity of the 1981-82 recession (peak unemployment near 11 percent) is qualitatively consistent with a monetary explanation, the vigorous 1983-84 recovery is not; for 1983-85 specifically he judges the joint behavior of the real exchange rate (the dollar appreciated more than 60 percent from its 1980 average to its February 1985 peak), the real economy, and the real interest rate “simply not consistent with a monetary explanation,” pointing instead to the 1981 U.S. tax-law change as his preferred real disturbance while explicitly declining to rule out competing explanations (e.g., the federal budget deficit) or offer a clean decomposition. On market expectations, drawing on published estimates from Roley and Troll (1983) and Roley (1986), Poole reports that the Treasury bill rate’s response to an unexpected $1 billion weekly M1 surprise rose from a “trivial” 1.6 basis points under the Federal Reserve’s October 1977-October 1979 interest-rate-control procedure to 10.4 basis points under its October 1979-October 1982 nonborrowed-reserves targeting procedure, before falling to 3.4 and then 1.4 basis points as the Fed reverted toward interest-rate control – evidence, in Poole’s reading, that the informativeness of money-stock announcements to markets is endogenous to the Fed’s own operating procedure rather than a fixed structural parameter. Poole concludes that the steady-state case for a monetary rule of constant money growth is essentially unaffected by this experience, but that the competing “gradualist” prescription – a pre-announced, stepwise reduction in money growth to engineer disinflation – is “unreliable,” since the 1981-1986 velocity decline was far larger than any conventional model would have predicted and, by his own explicitly “very casual” counterfactual reasoning, a gradualist money-growth path begun in 1980 would likely have produced deflation rather than the disinflation actually achieved.

William Poole | Macro Paper Warehouse

Monetary Policy Lessons of Recent Inflation and Disinflation