Ben S. Bernanke - 21st Century Monetary Policy: The Federal Reserve from the Great Inflation to COVID-19

21 ST
CENTURY
MONETARY
POLICY

The Federal Reserve from
the Great Inflation to COVID-19

BEN S. BERNANKE

W.W. NORTON & COMPANY

Independent Publishers Since 1923

THE WORD GREAT USUALLY HAS a positive connotation. In economicsnot so much. Unemployment soared and incomes fell sharply during both the Great Depression of the 1930s and the Great Recession of 20072009. Americas Great Inflation, which lasted from the mid-1960s until the mid-1980s, inflicted less economic distress than the other two great episodes. Nevertheless, the erasymbolized by gas lines and the Ford administrations famously futile Whip Inflation Now (WIN) buttonseroded Americans confidence in their economy and their government. For the Federal Reserve, the period had both low and high points. Facing political pressures and evolving views about the appropriate role of monetary policy, the Fed responded hesitantly and inadequately to the building inflation of the late 1960s and 1970s. But, under Paul Volcker, it took up and won the battle against inflation in the 1980s. The victory was costly, but it helped to restore confidence in economic policymaking and set the stage for two decades of strong economic performance.

As a childhood trauma shapes an adults 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. Critically, central banks incorporated the lessons of the period in a policy framework focused on controlling inflation and managing inflation expectationsa framework that remained highly influential, even as inflation receded. The experience of the Great Inflation, which showed how political pressure can distort monetary policy, also convinced many that monetary policymakers should make their decisions, to the extent possible, independently, based on objective analysis and in the long-run interest of the economy.

THE GREAT INFLATION: AN OVERVIEW

Before the 1960s, except during wartime and subsequent demobilizations, inflation had only rarely been a problem in the United States. Out of living memory, the worst inflations on American soil were during the Revolutionary Warwhen individual colonies issued their own currenciesand after the collapse of the Confederate currency during the Civil War. But neither of those episodes involved a currency issued by the federal government. During the Great Depression, the concern had been deflationrapidly falling pricesnot inflation. Inflation surged briefly at the end of World War II and again at the start of the Korean War. But it was largely quiescent from the early 1950s until the mid-1960s. The consumer price index (CPI)a measure of the cost of a standard basket of consumer goodsrose on average only about 1.3 percent per year between 1952 and 1965.

That began to change around 1966, when consumer prices rose a surprising 3.5 percent. The pace picked up from there, ushering in what would become a decade and a half of high and variable inflation. From the end of 1965 to the end of 1981, inflation averaged more than 7 percent annually, peaking at nearly 13 percent on average in 1979 and 1980. Americans had never experienced a sustained inflation this severe, and they didnt like it. By the late 1970s, high inflation regularly polled as the top economic concern, and people increasingly expressed little or no confidence in government economic policies.

Why did inflation rise so much after 1965? The economic doctrines of the time seemed to explain the rise, at least at first. A paper published in 1958 by A. W. Phillips, a New Zealander who spent most of his career

The Phillips curve captured an intuitive idea: If the demand for workers is high relative to the supplythat is, if employers have difficulty attracting and retaining workersthen workers should be able to command higher wages. Moreover, as many economists were quick to point out, the same basic idea should apply to the prices of goods and services. If demand is so strong across the board that firms are having trouble filling their customers orders, they will have more scope to raise prices. (Economists now distinguish between the wage Phillips curve, which links wage growth to unemployment as in the original Phillips paper, and the price Phillips curve, which ties consumer price inflation to unemployment or other measures of economic slack.) Basically, the logic of the Phillips curve is that inflation should accelerate when total demand from the private and public sectors persistently outstrips the capacity of the economy to produce.

That straightforward insight seemed to describe the late 1960s, when the economywide demand for goods and services grew rapidly. The main driver of demand growth was fiscal policy, the tax and spending policies of the federal government. Dissatisfaction with the economy had helped John F. Kennedy narrowly win the 1960 election. The economy had recovered only slowly from a recession in 195758, and another brief recession began as the election campaign was underway in 1960, pushing up unemployment through the year and into 1961. Kennedy had promised voters that he would get America moving again. Heller, a well-regarded economist from the University of Minnesota, led the economic team as chair of the presidents Council of Economic Advisers (CEA).

Keynes had advocated active use of fiscal policy to fight unemployment. The new president, following his advisers recommendations, proposed a wide-ranging tax cut to stimulate consumer and business spending. Kennedy was assassinated before his proposal could become law, but his successor, Lyndon B. Johnson, saw the tax cut through in 1964.

The tax cut was widely seen as a success. It helped bring down unemployment, which had peaked at 7.1 percent in mid-1961, early in Kennedys term, to 4.0 percent by the end of 1965. Meanwhile, Johnson announced his War on Poverty in January 1964, and both Medicare and Medicaid were introduced in 1965, committing the government to pay medical costs for retired and low-income Americans. Many Great Society programs would ultimately have important benefits, including a significant reduction in poverty rates among over-65 Americans, but they also had the effect of adding further to government spending.

As the economy heated up and unemployment fell (to about 3.5 percent in 196869), wages and prices began to accelerate, much as simple Phillips-curve reasoning would have predicted. Health care provides an example: With the advent of Medicare and Medicaid boosting the demand for medical services, the rate of increase in the price of health care jumped Meanwhile, nominal defense spending rose 44 percent between 1965 and 1968, leading military contractors to ramp up production and employment. The economywide inflationary impact might have been mitigated if higher taxes had paid for at least some of the increased spending, thereby reducing private-sector purchasing power. But the war was unpopular, and Johnson resisted any significant tax increase for fear that it would further diminish public support. (The president did approve, in 1968, a one-year 10 percent surcharge on personal and corporate income taxes, butprobably because it was understood to be a purely temporary measureit did little to slow private spending.)

Fiscal policy, through tax increases or spending cuts, is not the only tool that can cool an overheating economy. Monetary policy can too. In the 1960s, a tighter monetary policyin the form of higher interest ratesmight have reduced housing construction, capital investment, and other private-sector spending by enough to compensate for the expansion in federal spending. However, for reasons we will explore shortly, the Fed did not tighten monetary policy sufficiently or persistently enough to offset the building inflationary forces.