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

Questions & answers

Q1. Why does the paper treat the federal funds rate, rather than the money stock, as the object of study?

Because the Fed’s actual policy instrument throughout the period was the funds rate (directly or via borrowed-reserve/nonborrowed-reserve targeting mechanisms that ultimately controlled it), and the paper’s aim is to study “the short-run interactions between Fed policy and other economic variables” (Section 1, p. 3). The author argues that even the October 1979-October 1982 nonborrowed-reserve targeting period, often described as automatic, was “more accurate to refer to… as one of aggressive federal funds rate targeting than one of nonborrowed reserve targeting,” since Cook’s (1989) breakdown shows “two-thirds of funds rate changes were due to judgmental actions of the Fed and only one-third resulted from automatic adjustment” (p. 4).

Q2. What, precisely, is an “inflation scare,” and why is it central to the Fed’s dilemma?

A significant rise in the long-term bond rate that occurs without an aggressive funds-rate tightening, which the author reads as a real-time signal that expected long-run inflation is rising and the Fed’s credibility is slipping (p. 8). “Inflation scares present the Fed with a fundamental dilemma”: resisting a scare “requires the Fed to raise real short rates with potentially depressing effects on business conditions,” while “hesitating to react is also costly… by revealing its indifference to higher expected inflation the Fed actually encourages workers and firms to ask for wage and price increases to protect themselves from higher expected costs” – after which “the Fed is then inclined to accommodate the higher inflation with faster money growth” (p. 2).

Q3. How does the paper justify reading the long rate as a signal of inflation expectations rather than just future funds-rate expectations?

By arguing the long rate is an average of expected future short rates plus a roughly stable real-rate component, so a long-rate rise that is not simply tracking the current funds rate move must reflect a change in expected inflation (Section 1, “Interpreting Co-Movements,” p. 6-8). The Fed “anchors the short end of the term structure of interest rates to the current federal funds rate” through arbitrage across money-market instruments, and “average future short rates over the horizon of a 30-year bond should sum to a real interest rate that varies in a range perhaps 1 or 2 percentage points around 3 percent per year plus the expected trend rate of inflation” (p. 6), so persistent long-rate movements not explained by the current funds-rate target’s pull are attributed to shifting inflation expectations.

Q4. What happened in the March 1980 credit-control episode, and why does the paper treat it as pivotal?

The Fed had begun an aggressive tightening in October 1979 that, by early 1980, showed signs of taking hold and building credibility – “when one considers that business peaked in January, there is reason to believe that inflation would have come down as the recession ran its course in 1980 if the Fed had then sustained its high interest rate policy” – but the March 1980 imposition of credit controls “forced the Fed to abort that policy” (p. 12). Citing Schreft (1990), the paper attributes the resulting “extremely sharp −9.9 percent annualized decline in real GDP in the second quarter of 1980” largely to the credit-control program’s effect on consumer spending (which accounted for about 80 percent of the output decline, more than twice its average postwar share), and treats this interruption – along with a prior brief hesitation in the tightening and a subsequent automatic funds-rate decline in early 1981 – as one of “three unfortunate interruptions [that] account for the delay in the Fed’s acquisition of credibility” (p. 16, Observation 4).

Q5. How does the paper characterize the 1983-84 inflation scare, and what does it show about the fragility of credibility?

Even a year after the Fed had relaxed its disinflationary policy in late 1982, with inflation running under 5 percent, the long rate rose from 10.5 percent in May 1983 to 13.4 percent by June 1984 – “initiating an inflation scare only a year after the Fed had relaxed its disinflationary policy” (p. 13). Containing it required raising the funds rate to an 11.6 percent peak and sustaining roughly 7 percent real short rates, bringing real GDP growth down to a “more normal 2 to 3 percent range” by late 1984 (p. 14); the author reads the scare’s severity, occurring so soon after apparent success, as evidence of how “fragile” the Fed’s credibility still was in 1983-84 (Conclusion, p. 18).

Q6. What surprised the author about how aggressive funds-rate actions moved the long rate?

Rather than moving the long rate in the opposite direction (as a naive read of “easing lowers rates” might suggest), aggressive funds-rate actions moved the long rate in the same direction, primarily by pulling on the shorter end of the term structure, with reversals only near cyclical peaks and troughs (Section 3, Observation 3, p. 16-17). “The aggressive actions moved the long rate in the same direction, apparently influencing the long rate primarily through their effect on shorter maturity rates… The long rate appeared to be influenced by a change in expected inflation only after sustained aggressive funds rate actions” (p. 16-17) – consistent with the paper’s real-rate-versus-inflation-expectations decomposition, in which the real-rate effect of an aggressive move typically dominates in the short run.

Q7. What asymmetry does the paper find between easing episodes in 1980-87 versus the early-1990s recession?

In three earlier episodes (summer 1980, summer 1983, spring 1987), the Fed “could not push the funds rate more than 1 or 2 percentage points below the long rate before triggering an inflation scare,” but in the 1990-92 easing it pushed the funds rate roughly 4 percentage points below the long rate without triggering one (Section 3, Observation 6, p. 17). The author attributes this greater “latitude” to reduce short rates to accumulated credibility, comparing it to the similarly wide gap the Fed could open in early postwar recessions (1957-58 and 1960-61) “when the Fed presumably had more credibility” (p. 17), and suggests the exact real-rate floor at which easing becomes “excessive” depends on cyclical conditions such as unemployment, fiscal policy, and investment/consumption demand.

Q8. What policy recommendation does the paper draw from the recurring cost of inflation scares?

That a congressional mandate for price stability could reduce the frequency and cost of inflation scares and thereby give the Fed more room to respond to unemployment in the short run (Section 3, Observation 7; Conclusion, p. 17-19). “By reducing the risk of inflation scares, such a mandate would free the funds rate to react more aggressively to unemployment in the short run. Thus, a mandate for price stability would not only help eliminate inefficiencies associated with long-run inflation, it would add flexibility to the funds rate that might improve countercyclical stabilization policy as well” (p. 17); the author notes the Bundesbank and Bank of Japan “follow interest rate policies resembling the Fed’s and yet, for the most part, they have achieved better macroeconomic performance,” speculating this may reflect their “stronger mandate for price stability than does the Fed” (p. 19).