From preemptive tightening to preemptive easing : The evolution of U.S. monetary doctrines and practices in the Great Moderation

Abstract

The period in between the "Great Inflation" of the 1970s and early 1980s and the "Great Recession" of the late 2000s was described as a "Great Moderation" by central bankers and macroeconomists due to a pronounced moderation of output volatility while inflation became low and relatively stable. This economic performance was in part ascribed to the stabilizing influences of central bankers and their pursuit of "price stability." Other core beliefs contributed to the emerging consensus as well, such as notions of a "natural" rate of unemployment, the role of expectations among market participants, and strong-held views on how central bankers should respond to large-scale fluctuations in asset prices. These core beliefs, how they evolved and in what ways they contributed to shape the practice of policy is the topic of this study. An investigation into the development of monetary policy during this period leads to the following question:

How did U.S. monetary doctrines and practices evolve during the Great Moderation, and which main factors contributed in shaping these developments?

To shed light on this question, three episodes of monetary practice will be given ample attention. The first episode culminated with the 1994 decision to prevent an upward tick in inflation, even though no such inflationary pressures were apparent in indicators of consumer price growth at the time these actions were taken. The second episode was decisions in the late 1990s to discontinue the practice of raising rates when indicators of strong growth and tight labor markets suggested the need to cool down the economy. The third episode was the 2003 FOMC decision to take out an “insurance policy” towards a potential, but unlikely, downside risk of deflation. Whereas the first episode involved an act of preemptive monetary tightening, the third episode represented the opposite, a move towards preemptive monetary easing. The second episode falls somewhere in between, and can be seen as a transitional step towards a new policy regime.

It will be argued that perceived threats was a main contributing factor to the development of the doctrines informing monetary practices of this period. The stance towards preemptive tightening was motivated by the lessons drawn from the Great Inflation of the 1970s and early 80s. However, during the 1990s and early 2000s, the familiar inflationary foe was gradually surpassed by two other major concerns of which the Fed had less experience—a fear of financial fallouts and a fear of deflation. Both emanated from observed real time events, notably a period of global financial turbulence and certain unsettling economic developments taking place in the world’s second largest economy, Japan.