The Phantom Menace
The Fed during the 1990s
"I find your lack of faith disturbing."
- Darth Vader
Is the Fed’s “Epic Fail” partly a result of not following inflation targeting? I teased that idea at the end of my last post. As my summary of inflation targeting in that post suggests, inflation targeting is a framework for setting monetary policy that focuses only on the rate of inflation. What that means in practice is that there is no “coming to the rescue” during a recession to save the labor market. An inflation targeter would only try to stimulate real GDP if they felt inflation needed to be higher.
With inflation hitting 8.6 percent last month, it’s logical to ask why the Fed didn’t adopt inflation targeting back in the 1990s, like other central banks? To answer this, we need to travel back in time to the late-1980s and 1990s.
The Chosen One
In August of 1987, Alan Greenspan replaced Paul Volcker as chairman of the Federal Reserve. He remained chair until 2006. The Greenspan Era is notable for many reasons, one of which is that during the 1990s the rate of inflation in the United States declined yet real GDP growth was strong. We can see that looking at annual growth rates for each variable:
With respect to inflation, in particular, the Fed did just as well as the inflation targeters, as shown in the Figure below.
The Greenspan era is also notable as it embodies the “Just Do It” approach of setting monetary policy. I briefly summarized the Just Do It approach before, using it as an example of “discretion” in setting monetary policy.1 The approach also serves as an alternative to inflation targeting and, at least on paper, is an inferior approach. To see what I mean, consider some of the characteristics of the Just Do It approach as well as some context from the 1990s:
Just Do It is less transparent than inflation targeting. During the 1990s, the Fed never explicitly said what inflation rate it was targeting. In fact, they did not formerly announce a specific number (2 percent) until 2012.
Just Do It lacks explicit accountability. This is a natural implication of the previous point. In the 1990s it wasn’t clear if the Fed was hitting their target or not. They didn’t tell the public what the target was.
Just Do It has a higher chance of causing instability. Back then—way more so than now—market watchers had to constantly guess what the Fed was going to do with very little guidance. The Fed did not publish forecasts as they do now. They did not hold press conferences as they do now. And they did not provide forward guidance as they also do now. In fact, over the course of the 1990s it was popular to use the thickness of Alan Greenspan’s briefcase as an indicator of whether or not the Fed would raise rates or not. Yes, that’s right, his briefcase. That really was a thing.
Back then, as they still do, the Fed used Just Do It to satisfy its dual mandate. Inflation targeters have only one mandate. To be fair, the Fed did not have a choice between a dual or a single mandate (nor do they now).
However, in spite of all that, Greenspan and the Fed did just as well as the inflation targeters. Over that time, Greenspan became something of an economic hero. He even appeared on the cover of Time magazine a couple of times, each time being lauded (Time magazine was a big deal back then). Bob Woodward even wrote a book about Greenspan with the title, “Maestro.” Greenspan was the Chosen One, or so it seemed.
This is not the Monetary Policy you are looking for
On the flipside of the Greenspan-as-Maestro narrative is the reality that yes, the Fed did just as well as the inflation targeters; but, the inflation targeters did just as well as the Fed. So maybe we all got lucky, and the focus on Greenspan and the Fed was misplaced. Recall that with the Just Do It approach, the policy makers use their judgement to make decisions. And while inflation targeters also use their judgment, the framework is much more restrictive and consistent over time. Importantly, the framework is not dependent on the personalities and personas of the policy makers.
What does this have to do with 2022 and the most recent 8.6 percent rate of inflation? Consider the following narrative:
Maybe we were seduced by the Fed’s success and their Just Do It approach in the 1990s. This seduction led to monetary policy that stoked a housing market boom and subsequent crash, the financial crisis of 2008, and the Great Recession that ensued. And while Greenspan and the Fed did catch a lot of heat after the economy imploded, the Fed doubled down on the Just Do It approach during the 2008 crisis and during and after the Great Recession. They created and employed a host of entirely new methods and means to flood the economy with money. Indeed, in many circles, the Fed’s reputation was enhanced during the 2008 crisis, affirming the seduction. Thereafter, the economy recovered—with almost ten years of consistent growth (albeit very low growth) and low and stable inflation—leaving little impetus to deviate from the Just Do It approach.
In other words, as we find ourselves in 2022, the Fed has had three decades worth of “reputation capital” built up. Up to this point, the Just Do It approach for monetary policy appeared to work, even during 2020. But maybe now we are seeing the curtain pulled back on the dark side of the strategy. Jerome Powell and the Fed made a critical mistake by failing to pounce on inflation back in 2021, instead letting real GDP reach historic heights. Now, we are reaping the fallout from their misjudgment.
This narrative is speculative, of course. However, it seems clear to me that the Fed and their Just Do It approach has failed us.
Frederic Mishkin—notable macroeconomist, textbook author, and former member of the Fed’s Board of Governors—coined the phrase, “Just Do it Approach” as it relates to monetary policy.