FROM THE OFFICE OF PUBLIC AFFAIRS To view or print the PDF content on this page, download the free Adobe® Acrobat® Reader®. October 7, 2004 The International Implications of October 1979: I am pleased and honored to be here to share my thoughts on the momentous event that occurred on Anyone who was more than just a casual observer of economic policy making at the time realized that the measures announced on October 6 represented a major change in the conduct of monetary policy. If pursued to their conclusion, the measures would break the back of a vicious cycle of accelerating prices. If translated into new lasting principles of monetary policy, the specific measures would represent a true "regime" change. However, armed with monetary policy models that incorporated both inflation momentum and rational expectations, I also realized that tighter control of money was going to be associated with considerable economic strain for a period of time--not as bad or as long lasting a strain as some pessimists had predicted, but a severe strain nonetheless. This would require exceptional fortitude by the Federal Reserve and broad support from elsewhere in the government. Events Preceding It is difficult today to appreciate how desperate the economic situation had become 25 years ago. It is difficult because the Needless to say, confidence in On However, the confidence of market participants in Volcker's ability to lead the Fed on a disinflationary path was shaken on September 18. On that day the Federal Reserve Board approved a discount rate hike of 50 basis points to accompany an FOMC decision to tighten policy. But the vote, publicly announced, was very close, only What followed was one of the most masterful efforts in history by the head of a central bank to deal with a growing national and international problem. In the weeks after the September meeting, Paul Volcker put together a package that received the support of every member of the Board and every Reserve Bank president. It contained three key items: First, a full percentage point increase in the discount rate; that appealed to those believing the situation called for another traditional dose of monetary medicine. Second, a marginal reserve requirement on managed liabilities of large banks; that appealed to those who wanted to take action to restrain the surge in bank lending. And third, the new reserve-based operating procedures. The new operating procedures allowed the Fed to say, with some legitimacy, that it was the market, and not the Fed, that was setting the level of the funds rate. The procedures also appealed to those who believed that a reserve-based operating procedure would result in more timely and sizable interest rate responses to inflation, which would help the Fed stay in front of rather than fall behind the inflationary curve. In retrospect that may have been the most lasting feature of the October 1979 measures. The procedures also offered more two-way flexibility for prompt downward movements in the federal funds rate, which appealed to those who voted against the September 18 discount rate hike, fearing the economy was already sliding into recession. The Aftermath of The sustained monetary restraint called for by the operating procedures implied a protracted period of economic weakness. It called for a degree of fortitude by Chairman Volcker and his colleagues that had been highly atypical of central banks in the late 1960s and 1970s. This had to have been a very lonely and nerve-wracking period for the Federal Reserve. Stories abound about the daily mail deliveries of scraps of two-by-fours from the ailing construction sector with inscriptions begging for relief, and about angry farmers who circled the Fed building on Chairman Volcker and his colleagues were resolute for the next couple years and their efforts, along with subsequent ongoing vigilance to prevent the economy from overheating, paid tremendous dividends for the Knowledge and Leadership The October 6 events and their immediate aftermath provide a wonderful case study on implementation of economic policy in practice. In my view, both knowledge and leadership are essential if one is to get the job done. Simply knowing the economic theory or proposing the economic reform is not enough. The Fed, under Chairman Paul Volcker, understood the true seriousness of the inflation problem. They and many others in academia and elsewhere understood the economic forces that were causing the rising inflation that had plagued the But implementing the solution required leadership and skillful coalition-building. As I have emphasized, the measures taken on International Impacts and the Spread of Knowledge and Leadership The To understand this diffusion of knowledge, note that two lasting monetary principles emerged from the specific monetary measures of
First is a commitment to price stability. A central bank needs to be committed to price stability, and this view is now widespread. Indeed, according to a recent survey of 94 central banks, 96 percent have price stability as a statutory goal.[3] A milestone in this area occurred in 1989 when
Second is the focus of central banks on more systematic and transparent procedures for setting the policy instruments in a way that will bring about the goal of price stability. Both theory and empirical studies indicate that monetary control is easier if monetary policy objectives are seen as credible, enabling economic agents to adjust their behavior to those objectives; and policy transparency has enhanced credibility. In comparing the pre and post October 1979 periods, one finds that monetary policy in the [1] Goodhart (2004) notes that the Bank of England was considering changing its operating procedures in 1979. The focus on price stability and on accompanying policy procedures has resulted in a sustained decline in inflation throughout the world. The developed economies showed a declining trend after 1980. Inflation in these economies fell from an average of 13 percent in 1980 to 2 percent in 1997, and has remained close to 2 percent since then--tracking closely the experience in the Inflation in the emerging markets remained persistently high well after the drop in the developed economies. By the mid 1990s, however, the changes in the monetary policy process had become more common throughout the world. The deceleration in inflation has been amazing. As recently as 1994 inflation in the emerging markets averaged 65 percent; over the last four years, in contrast, it has been around 6 percent. As inflation has declined so has its variability. In the developed economies inflation variability, as measured by its standard deviation, fell from 3.4 percent in the 1980s to 1.3 percent in the 1990s and so far this decade is less than 1 percent. In the emerging markets the variability of inflation fell from 24 percent in the 1990s to less than 1 percent this decade. There is now little difference between the variability of inflation in the developed and emerging economies. This remarkable accomplishment is a direct result of the changes in the monetary policy process that began 25 years ago. Reduction in Output Variability and the Long Boom Impressive as these results are, they are only one part of a good story. At about the same time that the Fed was implementing the famous October 6 measures, I published a paper with an estimate of an efficiency frontier between the variability of inflation and output, noting that, with policy in place up until that time, the In a Homer Jones Lecture I gave several years ago, I referred to this period of low output volatility in the The same phenomenon is found in other counties. In the developed economies as a whole the variability of the real GDP (measured as a deviation from trend), fell from 1.8 percent in the 1980s to 1.0 percent in the 1990s and has remained steady since then.[7] The experience of the [6] In the emerging markets, the decline in inflation is still recent, but some emerging market economies have already seen a lowering of the variability of output. In Several arguments are often cited for the improvement in the output-inflation variability frontier. According to the "good luck" argument, the number and magnitude of shocks hitting the world economy has declined. According to the "structural change" argument, supply shocks have a less pronounced effect on the economy as a result of changes in the structure of the economy. Some changes often cited include an increase in the service sector's share in the economy and improvements in inventory management. I prefer a policy explanation closely connected to the monetary policy changes that began in October 1979. Reducing substantially the boom-bust cycle has been an important contributor. Recessions in the post-war period typically have been preceded by rises in the rate of inflation. Thus, by keeping inflation low monetary policy has reduced the likelihood of recessions. Moreover, ending inflation and keeping inflation expectations low has given central banks the credibility to address adverse supply shocks. In the past, in the face of an oil price shock, central bankers were faced with the vexing choice of whether to cushion the loss in output or resist the upward pressure on prices. If they pursued the former, they risked dealing with higher and more entrenched inflation expectations. In contrast, around the globe today, people have become more confident that central banks are not going to allow such shocks to feed into more long-term inflation. As a result, central banks can respond more to the output and employment effects. It is informative to contrast the discussion of policy responses to the recent run-up in oil prices with discussions that took place in the early 1990s. At that earlier time, there was the widespread view that central banks had to steer a narrow course and provide resistance to the price-level effects of the shock so as to avoid reigniting inflation expectations. Today, the anti-inflation credibility earned over the past couple decades has served to anchor inflation expectations and give central banks more leeway to cushion the output effects. . Conclusion In sum, reflection on the international implications of the momentous event of October 1979 in the I am optimistic that policymakers in emerging market and developing countries are learning these lessons as well. Given the hyperinflation and economic instability these countries have experienced in the past, the rewards from better policy are huge. During the last few years, I have worked closely with policymakers in many countries. We have consistently supported these leaders as they implement policies that promote price stability and transparent systematic procedures for adjusting policy instruments. I am convinced these principles will bring substantial long-term benefits to this part of the world, too. [7] Trend output is calculated using a Hodrick-Prescott filter.
Boughton, James (2001), Silent Revolution: The International Monetary Fund 1979-1989, Clarida, Richard, Jordi Galí and Mark Gertler (1998), "Monetary Policy Rules in Practice: Some international Evidence," European Economic Review 42(6), pages 1033-1067. Goodhart, Charles A.E. (2004), Comments at Reflections on Monetary Policy Conference, Federal Reserve Bank of St. Louis, October 8. Mahadeva, Lavan and Gabriel Sterne, editors (2000), Monetary Frameworks in a Global Context,
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