The Great Moderation vs The Epic Fail
The Fed's fall from grace
In 1984 the “Great Moderation” was born. In 2019 it died and was cremated. RIP.
From those ashes the Epic Fail of 2022 has risen. On the heels of the most recent disastrous inflation reading, the Fed announced today not only another rate hike, but a rate hike of 75 basis points, the largest rate hike in one meeting since 1994.
As many have pointed out the Fed was late to heading off what now appears to be runaway inflation. Now they are trying to make up for that blunder. What is stunning about this is that for the prior three decades, the Fed appeared to manage the macroeconomy with a deft touch. That deft touch was likely a big part of the Great Moderation.
The Good ‘ol Days
The Great Moderation is the after in a before-and-after story of the U.S. economy. The period prior to 1984 was marked by higher and more volatile rates of inflation, and higher and more volatile rates of real GDP growth.
Around 1984, things changed. Thereafter, the macroeconomy was calmer, as if it had matured and left behind it’s impetuous youth.
The contrast can be seen in the macroeconomic data. The table below shows the averages and standard deviations of real GDP, the core CPI rate of inflation, and the all-items-CPI rate of inflation.
For each variable the Great Moderation is evident. Average real GDP growth declined, which is not great, of course. But, so too did the volatility of GDP (as represented by the standard deviation). The average rate of inflation—measured by either version of the CPI—declined notably, as did the volatility of inflation.1
The Great Moderation was global, too, in both developed and developing countries.
By the early 2000s a spate of research had taken note of the phenomenon, citing a number of possible explanations grouped more or less by the following labels:
Structural Change
Good luck
Monetary Policy.
An example of “structural change” includes changes to the labor market, technology, production methods, or all of the above. The “good luck” explanation of the Great Moderation centered on just that, good luck. We had simply gotten lucky that the economy had not been hit by shocks like the ones experienced during the 1970s, or so this explanation emphasized.
However, it is the third explanation—as you might guess—is the focus of our discussion.
It’s the Inflation, Stupid
What happened with monetary policy during the Great Moderation? Given the timing, one could point to the work of Paul Volcker as chair of the Fed in the early 1980s. He is well-known for slaying the dragon known as the “Great Inflation”—coinciding with the 1958 to 1983 period shown in the table above (technically, the Great Inflation is considered to have lasted from about 1965 through 1982).
The focus on Volcker, however, is too simple. Though he is certainly worthy of praise (such as this), it’s not as if he defeated Thanos and snapped the world instantly back to some idealized-inflation state. Rather, monetary policy during the Great Moderation evolved as a result of a confluence of factors, including the Great Inflation and Volcker’s gambit.
For the remainder of this post, I am going to highlight one of those factors, a monetary policy framework known as inflation targeting.
Inflation Targeting
The Great Inflation made everyone acutely aware of the havoc that high and variable rates of inflation inflict on a macroeconomy. As such, by the early 1990s a “movement” had begun. Central banks around the world became “Inflation Targeters.” An inflation-targeting central bank has only one mandate: fight inflation, at all costs. Such a singular focus is known as a “hierarchical” mandate, as opposed to a “dual mandate.” In fact, strict inflation targeters eschew focusing at all about the unemployment situation or output gap, except as it pertains to the inflation situation.
In relatively short order, many central banks around the world became inflation-targeters, with New Zealand, Canada and the United Kingdom leading the way. The Fed, on the other hand, followed the Just Do It approach, as I discussed here and will have more to say on later.
Where did the concept of inflation targeting come from? While academic macroeconomists had been hashing out the importance of expectations in setting monetary policy since the 1970s, the framework for the policy came not from some landmark academic study, but from 1989 legislation in New Zealand. By 1989, New Zealand legislators were fed up with the incompetence of a previous administration, paving the way for a monetary policy framework that would not only bind the hands of policy makers at the central bank—diminishing their discretion in managing the business cycle—but would also limit other entities in the national government from meddling with monetary policy (for a detailed history of the Kiwi experience, see here).
Why did New Zealand and other countries look to inflating targeting, in particular? Proponents of inflation targeting note that the benefits of the approach are many. One, the job of the policy makers at the central bank is crystal clear. Markets, citizens, wage-setters and everybody else knows what the central bank is trying to do and why. And, it’s clear if the policy makers succeed or not. All of this helps anchor inflation expectations which then helps keep inflation, well, anchored. Moreover, as inflation stays low and stable, such success enhances the credibility of the policy maker, which only further serves to keep inflation low and stable. It’s a virtuous feedback loop (check out a comprehensive overview if inflation targeting here).
Overall, the action of the early-adopters of inflation targeting helped usher in an era where inflation became the number one villain in the macroeconomy. Focus only on that villain and, guess what, real GDP will be smoother in the long run, too. In contrast, an inflation-targeter would say, juggling a dual mandate creates uncertainty, wreaks havoc on expectations, is ad hoc, and ultimately leads to bad outcomes.
The adoption of inflation targeting by so many countries coincided with the early years of the Great Moderation. Hence, it is natural to ask whether or not inflation targeting was the cause of the Great Moderation. That’s impossible to know for sure, of course. And it would too simple to ascribe the Great Moderation to just one factor. In the least, inflation targeting was one of the factors, in my view.
What we can say with certainty, however, is that thanks to inflation targeting, by the late 1990s—like Grunge music and Starter Jackets—it was cool to be an Inflation Hawk.
The Epic Fail?
One last note on the Great Moderation before I end this already-too-long of a post. The momentous loss of output and high unemployment rates during the Great Recession (2007 – 2010 era) led some to believe that the Great Moderation had ended then. Such a death knell was premature, as the ensuing decade showed. Now, however, it seems the Great Moderation is likely dead.
So, what happened? Part of the answer, I suspect, lies in what is not discussed in the inflation targeting section above, the Fed. The Fed was not an inflation targeter, certainly not during the 1990s. Were the seeds of the Epic Fail planted then? We’ll look at the Fed’s 1990s experience in the next post and see what it might tell us about today.
A seminal paper on this topic is by economists McConnell and Perez-Quiros (1999). They were among the first (if not the first) to highlight the importance of the change-point around 1984. For an overview of the topic see Davis and Kahn (2008) or explore a countless number of other papers on the subject here.