Federal Reserve Bank of Richmond Economic Quarterly | Macro Paper Warehouse

Interest Rate Policy and the Inflation Scare Problem: 1979-1992

Using the 30-year bond rate as a real-time signal of the public’s long-run inflation expectations, this narrative study of Fed federal funds rate policy from 1979 to 1992 argues that the central challenge of the disinflation era was managing repeated “inflation scares” – sudden jumps in the long rate even without loose policy – and that delays in responding to them, more than any single decision, explain why acquiring disinflationary credibility took as long and cost as much as it did. Treating the federal funds rate (not the monetary base) as the Fed’s actual policy instrument, the paper develops a decomposition of the long-term bond rate into a component anchored by the current funds rate target (via arbitrage across maturities) and a component reflecting the public’s expected long-run inflation rate, and classifies funds-rate/long-rate co-movements into purely cyclical actions, changes in the long-run inflation trend, and aggressive disinflationary or stimulative actions. Walking chronologically through the October 1979 switch to nonborrowed-reserve targeting, the March 1980 credit-control interruption, the 1981-82 disinflation, the 1983-84 and 1987 inflation scares, and the 1990-92 easing, the paper documents that aggressive tightenings pulled the long rate in the same direction as the funds rate (not the opposite, as one might expect), that long-rate volatility was unusually high until 1988, and that the funds rate peaked in October 1981 – a full two years after the disinflation began – in part because a temporary Fed hesitation in early 1980, the March 1980 credit controls, and automatic funds-rate declines under the nonborrowed-reserve operating procedure each interrupted the tightening. The paper concludes that the Fed’s disinflationary credibility remained fragile throughout the 1980s – a scare could recur even years after inflation had stabilized, as in 1983-84 and 1987 – and argues, by comparison with the Bundesbank’s and Bank of Japan’s stronger price-stability mandates, that a congressional price-stability mandate could reduce the frequency of costly inflation scares and thereby give the funds rate more room to respond to unemployment in the short run.

The New IS-LM Model: Language, Logic, and Limits

This article gives a simple, self-contained exposition of what King calls the “New IS-LM model” – a small, three-equation macroeconomic system, built from optimizing microfoundations and analyzed under rational expectations, consisting of a forward-looking IS equation (current output depends on expected future output and the real interest rate), a Fisher equation (the nominal rate equals the real rate plus expected inflation), and an expectational (“New Keynesian”) Phillips curve (current inflation depends on expected future inflation and the current output gap). King situates the model historically as the outgrowth of a “New Neoclassical Synthesis” that answers the rational-expectations-era critique of the original Hicksian IS-LM framework and its 1970s descendants, while explicitly noting the model is not itself derived from first principles in this article but is instead a distillation used to communicate results from more fully articulated, microfounded models. Working through the model’s implications, King shows that a “neutral” monetary policy – one that always keeps output at its capacity level – implies a specific, and in general history-dependent, inflation target: inflation should be exactly zero if there are no exogenous “inflation shocks,” and otherwise the target should absorb the persistence properties of those shocks while never responding to shocks to aggregate demand, capacity growth, or money demand. He derives the forward-looking New Keynesian Phillips curve explicitly from Calvo-style staggered, forward-looking price-setting by monopolistically competitive firms, under an admittedly “heroic” assumption linking real marginal cost to the output gap, and shows the resulting curve implies essentially no long-run trade-off between inflation and output, even though nominal disturbances can still generate output effects that persist for many periods – resolving an apparent tension between the model’s long-run classical neutrality and the empirically persistent business cycles that motivated earlier “old Keynesian” IS-LM analysis. Turning to policy-rule design, King shows that interest rate rules of the Taylor type must satisfy restrictive parameter conditions – broadly, an “aggressive” response of more than one-for-one to inflation – to guarantee a unique, stable rational-expectations equilibrium rather than a continuum of self-fulfilling “sunspot” equilibria, and demonstrates the specific and somewhat counterintuitive result that this zone of admissible, determinacy-preserving rules is actually smaller (the zone of indeterminacy larger) once prices are sticky than in the flexible-price benchmark, with the exact boundary conditions differing sharply depending on whether the rule responds to current or expected future inflation. He closes by explicitly flagging the model’s own limits: it cannot, from within itself, justify why output stabilization at capacity is welfare-improving, define what an “inflation shock” actually is at a structural level, or evaluate the consequences of omitting investment and capital altogether – questions that, King stresses, can only be answered by stepping outside the New IS-LM model into the fully articulated, microfounded models it is meant to summarize.

The Phases of U.S. Monetary Policy: 1987 to 2001

Dividing 1987-2001 into six phases, this narrative traces how the Federal Reserve pursued the same four objectives – credibility for low inflation, accommodating productivity-driven growth, containing financial-market distress, and stimulus when needed – through remarkably varied circumstances. Phase 1 (October 1987-July 1990) covers the Fed’s liquidity response to the stock market crash and the inflation scare and entrenched inflation that followed its slow, delayed tightening response; Phase 2 (August 1990-January 1994) covers the Gulf War recession and the gradual disinflation that followed. Phase 3 (February 1994-February 1995) is the paper’s central success story: a preemptive tightening from 3 to 6 percent undertaken while inflation was stable at 2.5-3 percent, which “succeeded in its main purpose: to hold the line on inflation without creating unemployment” and laid the foundation for the long boom, even as the public came to misattribute the resulting low inflation to an independent “death of inflation” rather than to the Fed’s own preemptive action. Phase 4 (January 1996-May 1999) covers the long boom, in which the Fed had to learn to operate with newly won “near full credibility” for low inflation – itself a complication, since both the Fed and the public tend to overestimate noninflationary potential output once credibility is secured – compounded by genuinely rising but hard-to-measure trend productivity growth. Phase 5 covers the 1999-2000 tightening against overheating, and Phase 6 covers the collapse of business investment and the 2001 recession, in which the Fed cut the funds rate by 4.75 percentage points in real terms without triggering an inflation scare, “because of the near full credibility for low inflation” built up over the preceding decade. The paper’s overall argument is that despite the surface variety of the problems – financial crises, two wars, a productivity boom, an investment bust – the Fed’s policy actions throughout can be understood as consistently serving the same small set of objectives, with the 1994 episode standing as the clearest illustration of preemptive, credibility-building policy in action.