21st Century Monetary Policy

1. The Great Inflation: A Cautionary Tale of Policy Missteps

As a childhood trauma shapes an adult’s personality, the Great Inflation shaped the theory and practice of monetary policy for years to come, both in the United States and around the world.

Inflation's Rise: The Great Inflation, from the mid-1960s to the early 1980s, was a period of sustained high inflation, averaging over 7% annually. It was fueled by a combination of factors, including expansionary fiscal policy (Vietnam War spending and Great Society programs), misinterpretations of the Phillips curve (believing low unemployment could be sustained without inflation), and destabilized inflation expectations. The Nixon administration's wage and price controls proved ineffective, and oil price shocks further exacerbated the problem.

Policy Failures: The Federal Reserve, under Chairmen William McChesney Martin Jr. and Arthur Burns, responded inadequately to the building inflationary pressures. Martin, though initially concerned, was pressured by the Johnson administration to keep monetary policy easy. Burns, influenced by a cost-push theory of inflation, favored wage-price controls over tighter monetary policy, and was also pressured by the Nixon administration to keep rates low. These policy missteps allowed inflation to spiral out of control.

Lessons Learned: The Great Inflation demonstrated the dangers of political interference in monetary policy, the importance of controlling inflation expectations, and the need for central banks to act independently and decisively. It also highlighted the limitations of wage-price controls and the importance of understanding the complex relationship between inflation and unemployment. The experience shaped the Fed's approach to monetary policy for decades to come, emphasizing the need for price stability as a foundation for sustainable economic growth.

2. Volcker's Boldness: Restoring Credibility Through Pain

Paul Volcker, who served as Fed chair in the 1980s and was no pushover himself, would later write that Martin, “for all his friendly manner and personal modesty, had an iron backbone when it came to policy and the defense of Federal Reserve independence.”

Volcker's Appointment: In 1979, with inflation spiraling out of control, President Carter appointed Paul Volcker as Fed chair. Volcker, a man of imposing stature and a reputation for toughness, was determined to break the back of inflation, even at the cost of a recession. He understood that the Fed had lost its credibility as an inflation fighter and that restoring it was essential.

Monetary Tightening: Volcker's Fed adopted a monetarist approach, focusing on controlling the money supply rather than targeting interest rates. This led to a sharp increase in interest rates, with the federal funds rate reaching nearly 20%. The result was a deep recession in 1981-82, with unemployment peaking at nearly 11%. The recession was painful, but it was necessary to break the cycle of high inflation and high inflation expectations.

Restoring Credibility: Volcker's persistence and the Fed's willingness to endure political pressure ultimately paid off. Inflation fell from double digits in 1979-80 to about 4% by 1982. The victory was costly, but it restored the Fed's credibility as an inflation fighter and set the stage for two decades of strong economic performance. Volcker's actions demonstrated that central banks, if sufficiently credible and persistent, can control inflation, even when it is deeply embedded in expectations.

3. Greenspan's Era: Navigating Growth and Bubbles

As the response of the Powell Fed to the pandemic showed, the Fed’s tools, policy framework, and communications have changed radically since the 1951 Treasury-Fed Accord freed the central bank to pursue macroeconomic objectives.

The Great Moderation: Alan Greenspan, who succeeded Volcker as Fed chair in 1987, presided over a period of strong economic growth and low inflation, known as the Great Moderation. He consolidated Volcker's gains against inflation and managed monetary policy with a deft touch, informed by his deep knowledge of economic data. He also navigated a series of international financial crises, including the 1994 Mexican peso crisis and the 1997-98 Asian financial crisis.

The Dot-Com Bubble: Greenspan's tenure also saw the rise and fall of the dot-com bubble. He was aware of the potential for a bubble in stock prices and even used the phrase "irrational exuberance" to describe the market's behavior. However, he was reluctant to use monetary policy to directly target asset prices, believing that it was difficult to identify bubbles and that such interventions could have unintended consequences.

Financial Stability Concerns: While Greenspan was successful in managing inflation and promoting growth, he was less successful in preventing the buildup of financial imbalances. He was criticized for not paying enough attention to asset prices, especially stock prices, and for not doing enough to regulate the growing shadow banking system. His overconfidence in the power of market forces to discipline risk-taking would ultimately have significant consequences.

4. The 21st Century Challenge: Low Rates and Financial Instability

The second development is the long-term decline in the normal level of interest rates.

The Lower Bound: The 21st century has presented new challenges for monetary policymakers, including a long-term decline in the neutral interest rate, the rate that prevails when the economy is at full employment with stable inflation. This decline, driven by factors such as lower inflation, slower population growth, and a global savings glut, has reduced the scope for central banks to cut interest rates to stimulate the economy during downturns.

Financial Instability: The 21st century has also seen an increase in the risk of systemic financial instability. The 2007-2009 global financial crisis demonstrated that severe financial instability is not an historical curiosity but a real threat to even the most advanced economies. The crisis forced the Fed to develop new tools for fighting financial instability, including large-scale securities purchases and emergency lending programs.

New Questions: These developments have raised new questions for monetary policymakers: How can the Fed and other central banks support the economy when short-term interest rates are near zero? What new tools can be used? What role should fiscal policy play in stabilizing the economy? And to what extent should monetary policy take financial-stability risks into account?

5. QE and Forward Guidance: The Fed's New Toolkit

As the response of the Powell Fed to the pandemic showed, the Fed’s tools, policy framework, and communications have changed radically since the 1951 Treasury-Fed Accord freed the central bank to pursue macroeconomic objectives.

Quantitative Easing (QE): When short-term interest rates hit zero during the global financial crisis, the Fed turned to quantitative easing (QE), large-scale purchases of longer-term securities, to lower longer-term interest rates and ease financial conditions. QE works through two main channels: the portfolio-balance channel, which reduces the supply of longer-term securities held by the public, and the signaling channel, which signals the central bank's commitment to keeping policy easy for an extended period.

Forward Guidance: The Fed also began to use forward guidance, communicating its intentions about future policy to shape market expectations. Initially, forward guidance was qualitative and vague, but over time it became more explicit, including promises to keep rates low until certain economic conditions were met. Forward guidance, if credible, can lower longer-term interest rates and ease financial conditions, even when short-term rates are at the lower bound.

Effectiveness and Limitations: QE and forward guidance have proven to be effective tools for stimulating the economy when short-term rates are constrained by the lower bound. However, they are not a panacea. The effects of QE can be difficult to predict, and forward guidance can be misinterpreted by markets. Moreover, these tools may not be sufficient to fully compensate for the limitations imposed by the lower bound, especially in deep recessions.

6. The Pandemic Response: A Test of Innovation and Resolve

As I often remarked when I led the Fed, monetary policy is not a panacea. But money matters—a great deal.

Unprecedented Shock: The COVID-19 pandemic in 2020 presented the Fed with an unprecedented challenge. The pandemic caused a sudden and severe contraction in economic activity, with massive job losses and widespread business closures. It also triggered a financial panic, with sharp declines in stock prices and disruptions in credit markets.

Swift and Decisive Action: The Fed responded swiftly and decisively, cutting the federal funds rate to near zero, restarting its QE program, and establishing a range of emergency lending facilities to support financial markets and institutions. It also worked with Congress and the Treasury to establish new programs to backstop corporate and municipal bond markets and to finance bank loans to medium-sized businesses and nonprofit organizations.

Innovation and Adaptation: The Fed's response to the pandemic demonstrated its ability to innovate and adapt to new challenges. It used its existing tools more forcefully and creatively, and it developed new tools to address the specific problems posed by the pandemic. The Fed's actions helped to stabilize financial markets, smooth the flow of credit to the economy, and support consumer and business spending.

7. The Future of Monetary Policy: Navigating Uncertainty

The aim of this book is to help readers understand how the Federal Reserve, the steward of U.S. monetary policy, got to where it is today, what it has learned from the diverse challenges it has faced, and how it may evolve in the future.

Ongoing Challenges: The Fed faces a number of ongoing challenges, including the long-term decline in the neutral interest rate, the increased risk of financial instability, and the need to address social issues such as climate change and economic inequality. These challenges will require the Fed to continue to innovate and adapt its policies and strategies.

New Tools and Frameworks: The Fed has developed a new toolkit for monetary policy, including QE, forward guidance, and a more explicit focus on financial stability. It has also adopted a new policy framework, flexible average inflation targeting, which allows for temporary overshoots of the inflation target to compensate for past undershoots. These new tools and frameworks will help the Fed to better navigate the challenges of the 21st century.

The Importance of Independence: The Fed's independence from short-term political pressures is essential for its ability to make sound monetary policy decisions. The Fed must continue to defend its independence and to communicate its policies clearly to the public. It must also be open to new ideas and to learning from its own experiences and the experiences of other central banks. The future of monetary policy will depend on the Fed's ability to adapt to a changing world and to continue to serve as a steward of the U.S. economy.

Last updated: January 14, 2025