Risk Management in Monetary Policymaking: The 1994-95 FOMC Tightening Episode

Abstract

The 1994-95 tightening episode was one of the most notable in the FOMC’s history because the FOMC raised the policy rate by 300 basis points in a year, despite headline and core CPI inflation trending lower prior to the beginning of tighter policy in February 1994. Although Chair Alan Greenspan publicly signaled the FOMC’s desire to normalize its policy rate prior to February 1994, the Federal Reserve’s actions nonetheless caught the Treasury market by surprise, triggering a sharp decline in long-term bond prices. Chair Greenspan and the FOMC were regularly surprised that inflation was not rising by more than the forecasts suggested during the episode. This article presents some evidence that the Greenbook forecast systematically, albeit modestly, overpredicted CPI inflation during the tightening period. Still, the success of the episode stemmed importantly from the decision by Greenspan and the FOMC to increase the policy rate to a level deemed restrictive for most of 1995. The end result was the avoidance of a recession and an eventual slowing in inflation and inflation expectations.

Introduction

Federal Reserve System policymakers regularly confront numerous risks in their deliberations. The practice of risk management is one method of accounting for and responding to these risks. Historically, preemption has been an aspect of the risk management approach. That is, because it takes time for monetary policy actions to influence macroeconomic outcomes, the FOMC decides to raise or lower the federal funds target rate before inflation or unemployment rises or falls beyond levels deemed inconsistent with its Congressional mandates of price stability and maximum employment. In this sense, preemptive policy does not rely too heavily on the modal outcome of central bank projections.

A classic episode of U.S. preemptive monetary policy occurred in 1994 under the leadership of Chair Alan Greenspan, when the FOMC began to raise the federal funds target rate in response to the anticipation of an acceleration in inflation rather than an actual acceleration in inflation. Preemptive policymaking can be difficult in practice because many key economic data are backward looking and/or subject to revision. To compensate for these challenges, forecasts often play an outsized role in the monetary policymaking process. But forecasting models are fallible, particularly when subject to large macroeconomic shocks.

A key motivation for this article is to provide a reasonably concise summary of the 1994-95 episode for those interested in analyzing past episodes and the application, if anything, for current and future monetary policy deliberations.