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Money Maturity

The 1970s were a disappointing decade for monetary policy. The Fed had two conflicting goals. As a result of the Great Depression, full employment had become the primary goal of macroeconomic policy. However, inflation had risen so that it was now also seen as a problem. The Fed would attack inflation by tightening monetary policy. When unemployment rose as a result, the outcry from the public and politicians, and perhaps some wishful thinking by the Fed that they had finally solved the inflation problem, would persuade the Fed to shift gears and attack unemployment. Monetary policy flipped back and forth, first focusing on one goal and then the other, with ever worsening results. In the 1960s economists believed that the Phillips Curve provided a menu of unemployment-inflation options, and macroeconomic policy simply had to select one. The 1970s showed that this menu was an illusion.

As the Phillips curve dissolved, policy makers both in and outside the Fed changed their expectations of what monetary policy could achieve. A growing consensus emerged that the proper goal of the Fed was to control price level because that was something it could control. Attempts to control the unemployment rate were doomed to failure if the target rate were different from the natural rate. Once the belief became widespread that the Fed could not effectively control unemployment, the Fed was free to focus on inflation.

Given new resolve and new leadership under Paul Volcker, the Fed acted in 1979 to control inflation, which had risen to double-digit levels. In tightening monetary policy, the Fed fully realized that unemployment would rise as a side-effect, though it did not foresee that the unemployment rate would eventually exceed 10%. However, the Fed did not back down as it had done in the 1970s, and it killed double-digit inflation.

The experience of this episode as well as what happened early in the 1970s had a profound effect on the way the Fed saw its goals. Stable prices are desired because they contribute to economic growth. If inflation gets started, the only way to bring it down is to cut spending, which will cause a recession. Hence the best strategy will be to not allow spending to grow so rapidly as to spur a rise in inflation. Although controlling inflation was not the only goal of the Federal Reserve, it seemed to be its primary goal.

In the 1970s and early 1980s, the Fed experimented with the monetarist idea of targeting monetary aggregates. The Fed abandoned monetary aggregates when velocity became much more variable after 1980 than it had been previously. One reason for this increased variability in velocity is that financial innovation has blurred the lines between what is money and what is not money. In the words of one Federal Reserve publication, "Essentially there is no good match between the conceptual definition of money and the actual financial instruments that exist in the United States." 1

The Fed presently uses the federal funds rate as its policy target and indicator. Monetarists have always pointed out the danger of using an interest rate to judge whether monetary policy is tight or easy. If people expect 1% inflation, a 5% interest rate may be quite high, but if they expect 4% inflation, it is very low. However, given the poor correlations between money measures and total spending, there does not seem to be much choice but to use an interest rate as a target and hope that the Fed draws the right conclusions.

Finally, the Federal Reserve has become willing to tell the public what its goals are and how it is trying to achieve those goals. This is a revolution in the way the Fed operates because, for much of its history, the Fed was famous for its secrecy. This new openness may reflect both the experience of the 1970s and academic research on expectations. Macroeconomists now see people reacting not just to actual government policy, but to expectations of government policy. If government wants to surprise people, then it should keep its policy process secret. But if policy works better when people anticipate it, then the policy process should be open.

During the 1970s a major problem in getting inflation under control was that people expected inflation to continue. When government officials announced that they were taking action to cut inflation, the public did not believe them, and the public was usually right because their dedication to reducing inflation conflicted with other goals. The government, including the Federal Reserve, lacked credibility. A reason that the recession in 1980 was so severe was that many people did not believe that the Fed was serious about bringing down inflation and so they made decisions on the assumption that inflation would continue. When the Fed's the primary goal became controlling inflation, the Fed needed the public's trust and openness encourages this trust.

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1Meulendyke, Ann-Marie. U. S. Monetary Policy and Financial Markets. (New York: The Federal Reserve Bank of New York, 1998) p. 9.

Copyright Robert Schenk