Monetary Policy Rules, Macroeconomic Stability, and Inflation, A View from the Trenches

One view, associated with Clarida-Galí-Gertler (CGG) and Taylor, holds that pre-Volcker policy “accommodated inflation and induced instability in the economy by lowering real interest rates when expected inflation increased,” a “perverse practice” corrected when Volcker took over; the alternative view holds that policy was instead “excessively activist” in responding to perceived output gaps that proved “overambitious, retrospectively” (Section 1, p. 2). Orphanides notes that CGG’s own estimates rely on “ex post constructed data as proxies” for what policymakers knew, which “can lead to misleading descriptions of historical policy and obscure the behavior suggested by information available to policymakers in real time” (p. 3), motivating a real-time reestimation.

The paper reconstructs, for each quarter from 1966Q1 to 1995Q4, the FOMC staff’s Greenbook forecasts of nominal output, real output, and potential output/the output gap, using the headline definitions of “real output” in force at each point in time (Section 2.2, p. 6-7). Since there is no consistent record of the Committee’s own quantitative forecasts, Orphanides uses “a detailed record of policy discussions and information presented to the Committee by Federal Reserve Board staff,” starting in 1966 when systematic quarterly forecasts began (p. 6-7), and illustrates the forward-looking, Greenbook-centered nature of FOMC deliberations with parallel quotations from a 1994 and a 1965 meeting (p. 8).

Using real-time data, the estimated inflation-response coefficient β “exceed[s] one in both samples and [is] only slightly higher in the sample starting with Volcker’s appointment,” while the output-gap coefficient γ “for the 1960s and 1970s are more than twice as large as the corresponding estimates for the sample starting with Volcker’s appointment” (Section 2.3, p. 9). At the one-quarter horizon, the pre-Volcker β estimate is about 1.64, “about twice as large” as the 0.75-0.80 estimates reported by CGG (1998, 2000) using ex post quadratic-trend output gaps (Section 3.2, p. 13). Formal tests find only the output-gap coefficient γ differs significantly across the two periods, not β or the constant term α (Table 2, discussed p. 10).

Because the real-time output gap is strongly negatively correlated with the inflation forecast (−0.54 in the 1966Q1-1979Q2 sample) while the ex post quadratic-trend gap is essentially uncorrelated with it (0.04), omitting or mismeasuring the true real-time gap causes some of its explanatory power to be wrongly attributed away from itself and onto the inflation term (Section 3.2, p. 13). Orphanides demonstrates this directly: re-estimating the rule while forcing γ = 0 (i.e., mimicking the omission) drops the estimated β for the pre-Volcker sample to 0.94, “confirming a substantial downward bias” (p. 13).

Comparing real-time perceptions with an ex post quadratic-trend output gap, the two series track closely at the start and end of the sample but diverge into a “U-shaped pattern of misperceptions, with a low point around 1975,” consistent with policymakers only gradually learning about a slowdown in trend productivity that began in the late 1960s (Section 3.1, p. 11-12). “Throughout the 1970s, output appeared to fall short of the economy’s potential supply, increasingly so in the early and mid 1970s” in real time, even though ex post data show the gap had closed much earlier; correspondingly, inflation forecasts “systematically underpredicted inflation during the late 1960s and early 1970s” (p. 12).

Using the derived index γ/(β − 1) – the percentage-point inflation deviation implied by a persistent one-point output-gap misperception – the index is “around 1 for the policy rules describing the Great Inflation but only about one quarter as high for the post-1979 sample” (Table 3, p. 14). Combined with average real-time output-gap misperceptions of −4.9 percent before mid-1979 and −3.6 percent after, Orphanides estimates “an inflationary bias of about 4.4 percent before mid-1979” versus “only about 1.2 percent” after – so that “if policymakers implemented policy aiming towards a long-run inflation target of 2 percent, their actions were actually pushing the economy to an inflation rate above 6 percent” pre-Volcker (p. 14).

Because activist output-gap-chasing policy is only stabilizing if the output-gap signal is accurate, systematic real-time overoptimism about potential output turned the same activist rule into a source of instability – “a pattern of stop-go policy reversals that retrospectively appear to be out of sync with the economic fundamentals,” with policy “falling ‘behind the curve’” (Section 3.4, p. 15-16). The paper illustrates this with the 1970 recession: policy eased to restore growth, but while ex post data show output back at trend by early 1972, “based on the real-time perceptions of the output gap… the economy did not appear overexpanded even much later,” so the “resulting policy activism ignited inflation… [and] with inflation rising, policy tightened significantly by late 1973, raising the real rate to about four percent,” which, “with the economy already overextended,” precipitated the 1974-75 recession (p. 16-17).

Not a sudden jump in the weight on inflation in a formal rule, but a hard-won, real-time recognition – visible in the closely divided votes and internal disagreement of the 1979 meetings – that short-run output stabilization had to be set aside to address a “chronic inflationary problem” (Section 4, p. 17-20). Orphanides traces the sequence from the February 1979 Humphrey-Hawkins Report’s narrowing output-gap language, through split committee votes in March and May, to the “small but important turning point” of the July 19 and 27 rate increases taken “despite the view that the economy was likely already in recession” (p. 19), and quotes Volcker’s February 1980 testimony explaining that policy had too often been “prematurely or excessively stimulative… out of fears of recession,” producing “our now chronic inflationary problem” (p. 20) – evidence, in Orphanides’s reading, of “a reduction in emphasis to the output gap relative to inflation,” not a change in how strongly policy already responded to inflation itself (p. 9-10).

That monetary policy was “too activist, placing too much emphasis on short-run stabilization of economic activity at the expense of the Federal Reserve’s long-term price stability objective,” not that it responded perversely to inflation – and that this activism “would be workable” only “if only policymakers could have a solid understanding of the structure of the economy and reliable readings of the state of the economy,” which in practice they lacked and “also lacked an appreciation of their ignorance” (Section 5, p. 21). The 1979 shift, in this reading, worked “by reducing the excessive emphasis on stabilizing the level of economic activity around its uncertain potential and concentrating instead on the inflation outlook,” not by discovering that inflation itself needed a stronger coefficient (p. 21).