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

Questions & answers

Q1. What four objectives does the paper argue guided Fed policy consistently across all six phases?

“First of all, the Fed aimed to achieve and maintain credibility for low inflation. Second, the Fed managed interest rate policy so that the economy could attain the full benefits of rising trend productivity growth. Third, the alleviation of financial market distress dictated interest rate policy actions on occasion. Fourth, the Fed steered real short-term interest rates sharply lower when economic stimulus was needed” (Introduction, p. 2). The paper frames the entire narrative as an application of these four objectives across situations that “were remarkably varied,” arguing the underlying goals were “the same throughout” even as the specific policy problem changed from phase to phase.

Q2. What went wrong with the Fed’s response to inflationary pressure around the 1987 stock market crash?

Inflation expectations were “already evident in the 30-year bond rate,” which rose two full percentage points from March to October 1987, yet “the Fed reacted relatively little to the 1987 inflation scare,” and this “failure to respond created doubts that it would hold the line on inflation” (Section 1, p. 3-4). The bond rate did not return to its earlier level “until late 1992.” Goodfriend concludes “monetary policy restraint was delayed by a couple of years because the Fed was reluctant to act against inflation both before and after the crash,” so that by the time it did tighten (1988-89), it had to counteract inflation “already well entrenched,” requiring higher real rates and greater recession risk than a prompt response would have (Section 1, p. 4).

Q3. Why does the paper treat the 1994-95 tightening as “a textbook example” of preemptive policy?

Because the Fed raised the funds rate from 3 to 6 percent between February 1994 and February 1995 while “inflation showed little tendency to accelerate and remained between 2.5 percent and 3 percent” – tightening against a forecast risk rather than realized inflation – and “succeeded in its main purpose: to hold the line on inflation without creating unemployment,” with unemployment falling from 6.6 to 5.6 percent over 1994 despite the tightening (Section 3, p. 6). Goodfriend argues this “demonstrated that a well-timed preemptive increase in real short-term interest rates is nothing to be feared” and “laid the foundation for the boom that followed” (p. 6).

Q4. What paradox does the paper highlight about how the public interpreted the resulting low inflation?

That commentators attributed the subsequent stability to an autonomous “death of inflation” rather than to the Fed’s preemptive 1994 action: “the death-of-inflation talk was also disappointing because it tended to undervalue the role played by the Fed in ‘killing’ inflation… If inflation is to be contained permanently, the idea that inflation doesn’t just ‘die’ but must be periodically vanquished by proactive interest rate policy is one that the public must appreciate more fully” (Section 3, p. 6-7). The episode also triggered institutional friction: Congress, “unprecedented[ly],” invited all twelve Reserve Bank presidents to testify after objecting to the tightening, a dispute the paper says “probably contributed to the severity of the 1994 inflation scare in the bond market” by creating doubt about the Fed’s resolve (Section 3, p. 7).

Q5. Why does the paper describe the late-1990s “long boom” as harder to manage than the tightening that preceded it?

Because two genuinely beneficial developments simultaneously complicated policy: newly secured “near full credibility for low inflation,” and a rise in trend productivity growth whose magnitude was uncertain in real time. “When near full credibility for low inflation is newly won, both the central bank and the public tend to overestimate the economy’s noninflationary potential output,” meaning the very success of 1994 made it harder to judge, in real time, whether continued low measured inflation reflected a benign productivity-driven expansion or a masked buildup of pressure (Section 4, p. 7-8).

Q6. What ended the boom, and how does the paper explain the resulting 2001 recession?

A collapse in business investment following a period of overshooting: real nonresidential fixed investment “grew at around 10 percent per year from 1995 until 2000” before growth “collapsed to near zero in 2000Q4 and 2001Q1 and then contracted at more than a 10 percent annual rate” in the following two quarters, compounded by a swing from inventory accumulation to liquidation (Section 6, p. 14-15). The paper attributes much of the severity to financial amplification: “excessive equity values cheapened equity finance during the boom years, and the collapse of equity values raised the cost of equity finance during the slowdown,” while declining profits forced firms toward costlier external finance just as it became scarcer (Section 6, p. 15).

Q7. How does the paper explain the Fed’s ability to cut rates so aggressively in 2001 without setting off an inflation scare?

Directly to the credibility accumulated since 1994: the Fed cut the federal funds rate target “in 11 steps from 6.5 percent at the beginning of 2001 to 1.75 percent in December 2001,” a real cut of about 4.75 percentage points, and “the Fed was able to cut the real federal funds rate so far without precipitating an inflation scare because of the near full credibility for low inflation” built up over the preceding decade (Section 6, p. 15-16). The paper contrasts this favorably with the more constrained “leeway” the Fed had in earlier disinflations, while flagging the zero lower bound (only 1.75 percentage points of nominal room remaining) as a live risk should the recession deepen further (Section 6, p. 16).

Q8. What overall lesson does the paper draw from the period, given how varied the six phases were?

That no single overarching lesson emerges beyond the recurrence of similar challenges: “because the problems were so varied, it is difficult to draw overall lessons from the period, but one thing is clear. Similar challenges are likely to be encountered in the future and the experience gained in surmounting them should help the Fed improve monetary policy” (Conclusion, p. 16). The paper’s own summary of the period’s breadth – three financial crises (1987, the 1997 East Asian crisis, and the 1998 Russian default), two wars, and a transition to greater policy transparency after February 1994 – is offered as evidence that the four consistent objectives, not any single formula, are what unify the account (Conclusion, p. 16).