Monetary policy during the past 30 years with lessons for the next 30 years.

• Author: Taylor, John B.

The 30th anniversary of the Cato Institute's monetary conference series provides an excellent opportunity to take stock of what we have learned about monetary policy in the past 30 years and to draw lessons for the next 30 years.

Considering the overall performance of the American economy, the past 30 years divide naturally into two parts. During the first part--roughly the first two-thirds--economic performance was quite good, but during the second part it was quite poor. In terms of monetary policy, there is a corresponding natural division with a steadier rules-based approach to policy in the first part and a much less predictable discretionary approach to policy in the second.

The policy implication of this experience thus jumps out at you. To be sure, however, one needs to work carefully through the facts and follow the relationship between economic performance and monetary policy.

Economic Performance

Let's start with some charts which illustrate the key facts. Figure 1 shows the growth rate of real GDP from quarter to quarter in the United States. It is like an EKG for the American economy. It shows that the volatility of GDP growth declined markedly in the 1980s and 1990s. This period of greater economic stability is called the Great Moderation by many economists and is marked off by two vertical dashed lines in the chart. During this period expansions with positive growth were long, and recessions with negative growth were short. Following the back-to-back early 1980s recessions, there were only two recessions during this period and both were mild in comparison with other periods in American history.

Figure 2 shows the unemployment rate. It too declined during the period of the Great Moderation with relatively small ups mad downs corresponding to the two mild recessions. The 1980s and 1990s were especially good compared with late the 1960s and 1970s, when unemployment was rising.

Of course, it is equally obvious from Figures 1 and 2 that the good economic performance did not last. The Great Moderation came to an abrupt end with the Great Recession. And the poor performance has continued with an extraordinarily weak recovery compared to the recoveries from previous deep recessions with financial crises in the United States as shown by Bordo and Haubrieh (2012). The recovery from the deep 1981-82 recession was more than twice as fast as the recent recovery as shown by the circled areas in Figure 1. And the unemployment rate again went into double digits and has come down more slowly than in the early 1980s.

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Monetary Policy

During much of the same time period in the 1980s and 1990s and until recently, monetary policy was more predictable, less discretionary, and more steadily focused on the goal of price stability, especially compared with the 1970s. During this period the Fed largely avoided go-stop changes in money growth and interest rates that had caused boom-bust cycles in the past.

However, for the past decade or so, there has been a large deviation from the type of monetary policy that worked well in the 1980s and 1990s. It appears that the policy reversal started during 2003-05 when interest rates were held abnormally low, and it has continued during the more recent period of large-scale purchases of mortgage-backed securities (MBS) and longer-term Treasuries and of Fed statements that interest rates will be held at zero for several years into the future.

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Much as economic theory would predict, when monetary policy became more rule-like and focused, the performance of the macro-economy improved, and when policy reversed so did economic performance. Figure 3 is one way to show the charges in policy. (1) It plots the inflation rate, which declined from the peaks reached during the great inflation of the late 1960s and 1970s. To illustrate the shifts in monetary policy, I have drawn a line at 4 percent inflation. Observe, as shown by the boxes in the chart, that the Fed's policy interest rate--the federal funds rate--was much higher in 1989 when it was 9.7 percent than in 1968 when it was 4.8 percent even though the inflation rate and business cycle conditions were about the same. That larger response of the interest rate was a regular predictable characteristic of monetary policy in the 1980s and 1990s compared with the earlier period. It is one of the best ways to indicate that policy changed leading to less inflation and ushering in the Great Moderation.

To illustrate the shift back in policy, I have drawn in another line at 2 percent inflation. Observe...