Inflation and the Role of Fed Credibility

In the most recent issue of The Regional Economist, Federal Reserve Bank of St. Louis Vice President and Economist William Gavin and Research Associate Diana Cooke examined how the credibility of the Fed factors into its ability to effectively target inflation. Gavin and Cooke divided the Fed’s tenure into four time periods:

• The pre-1980s, when the Fed was operating without credibility in monetary policy
• 1980–1986, when the Fed was earning credibility
• 1987–2007, when the Fed was operating with credibility
• 2008–2013, when the Fed was dealing with unexpectedly low inflation in the wake of the financial crisis

The period of accelerating inflation during the 1970s eventually became known as the Great Inflation, as inflation rose from under 2 percent in 1965 to 14.4 percent in June 1980. Gavin and Cooke referred to this period as “an era of stop-go monetary policy.”  Inflation would rise, and the FOMC would raise the fed funds rate to slow it down. This would lower aggregate spending, reducing the demand for labor and leading to a recession. Then, the FOMC would sharply lower the fed funds rate to stimulate spending and job growth.

However, the mere act of raising the fed funds rate wasn’t enough to slow inflation expectations. To do that, the Fed had to set the rate higher than the rate on 10-year Treasury bonds (and do it quickly). Gavin and Cooke wrote, “Gaining credibility would require a period of prioritizing low inflation over low unemployment. Only then would long-run inflation expectations be set in a way that did not fluctuate with short-term interest rate policy.”

To combat the high inflation of the late 1970s and of 1980, the FOMC switched from targeting a narrow range for the fed funds rate to targeting a narrow range for bank reserves. As Gavin and Cooke wrote, “By targeting the interest rate, the Fed allows money demand fluctuations to be absorbed by accommodating fluctuations in money supply.”

When the recession ended in 1982, the FOMC was still worried about building credibility and once again raised interest rates to fight rising inflation. The tightening occurred during a major banking crisis and high unemployment (the unemployment rate never fell below 7.2 percent during the crisis), but the Fed’s willingness to stick with its policy convinced the public that it would take the necessary steps to maintain low inflation. The policy ultimately worked, as inflation fell to a low of 1.1 percent in December 1986.

A demonstration of the Fed’s credibility occurred in 1994. The FOMC had set the fed funds rate target at 3 percent in September 1992 and kept it there for 16 months, stoking fears of inflation. In October 1993, the 10-year rate began climbing from 5.3 percent to a peak of just under 8 percent in November 1994. Gavin and Cooke explained that the FOMC did not have to raise the fed funds rate above the 10-year rate to end the brief inflation scare. The FOMC began raising the fed funds rate target in February 1994 and raised it rather sharply to 6 percent in early 1995, but by then the 10-year rate had already started retreating. Declining 10-year bond yields reflected falling inflation expectations.

The Fed’s credibility was tested again during the recent financial crisis. The Fed flooded the market with bank reserves to prevent a worldwide collapse of financial markets, and this action drove the fed funds rate to 0. In December 2008, the FOMC set the target range for the rate at 0 percent to 0.25 percent.

In turn, the low fed funds rate has not only not led to higher inflation, but inflation and inflation forecasts have hovered below the 2 percent target of the FOMC. Gavin and Cooke noted, “During the Great Inflation, when the Fed did not have credibility, it was difficult for the Fed to stop the rise of inflation. Now, when credibility is deeply rooted, it seems just as difficult to stop inflation from falling.”

Gavin and Cooke pointed out that future monetary policy is uncertain because the outlook for interest rates, inflation and real economic growth is inconsistent with the Fisher equation, an equation from famed economist Irving Fisher stating that the nominal interest rate is equal to the real interest rate plus the expected rate of inflation. Gavin and Cooke offered three significantly different ways this inconsistency can be solved:

• The Fed loses credibility and 1970s-style inflation returns. This would mean real interest rates staying low, but inflation expectations and the 10-year rate rising rapidly.
• The Fed maintains credibility and people expect 2 percent inflation to continue indefinitely. This would mean a gradual rise in interest rates that is enough to prevent a loss of credibility to the Fed, but not so much it would cause another recession. This is the outcome that is considered most likely by private and government economic forecasters.
• The Fed keeps rates exceptionally low until the economic data clearly demonstrate that the economy is at full employment. However, predicting turning points in the economy cannot be consistently done.

• On the Economy: Lowflation in Advanced Economies
• On the Economy: Employment Is Back?  It Depends
• The Regional Economist: The Ups and Downs of Inflation and the Role of Fed Credibility