Interest-rate targeting during the great moderation: a reappraisal.

• Author: Garrison, Roger W.
• Position: Report

In the era that has come to be known as the "Great Moderation" (dating from the mid-1980s), the Federal Reserve's policy committee (the Federal Open Market Committee or FOMC) pursued what has to be called a "learning-by-doing" strategy. The data that counted as relevant feedback--the unemployment rate and the inflation rate--seemed all along to be suggesting that the Fed was doing the right things. Even when the Fed lowered the Fed funds target to 1 percent in June 2003 and held it there for nearly a year, the economy appeared to be on an even keel and U.S. interest rates were in line with those in other countries. The historically low interest rates were attributed not to excessive monetary ease in the United States but to a worldwide increase in savings.

But then came the two-year-long ratcheting up of the Fed funds target from 1 percent on June 20, 2004 to 5.25 percent on June 29, 2006, to stave off inflation. The FOMC reversed course, in response to softening labor markets and increasingly troubled credit markets, and began an even steeper ratcheting down on September 18, 2006, so that by April 30, 2007, the Fed funds target was at 2 percent. Subprime mortgages revealed themselves as being particularly troublesome, after which it became increasingly clear that the cumulative effects of deep-rooted financial innovations in mortgage markets had been leveraged into an unsustainable boom.

The bust involved problems of illiquidity and insolvency for the whole financial sector. The full-blown financial crisis that is still unfolding provides ample evidence that the underlying weakness in credit markets had been developing for a number of years and that the learning part of the learning-by-doing policy formulation had been seriously degraded--most dramatically by the financial innovations in the business of mortgage lending and mortgage holding.

The initial response by Washington was not surprising. The goal was to cobble together some bold sequence of stopgap measures to keep the crisis--whatever its ultimate causes--from feeding on itself. We should have serious doubts, however, that Congress, whose legislative acts have made the financial sector (and particularly the secondary mortgage markets) so crisis-prone, is somehow able to deal effectively with the crisis's self-aggravating potential. There are also doubts that even the self-aggravating aspects of the crisis can be effectively countered by legislators who have no understanding--or, worse, a profound misunderstanding--of the nature of the problem. Claims that jumbo-sized bailouts will deal with the debilitating uncertainties in the financial sector ring hollow in view of the open-ended uncertainties about just how the bailouts will be financed and just how they will be administered. Claims that just "doing something" may counter the fear factor and cure the economy's financial-sector woes (as if "we have nothing to fear but fear itself') are to be dismissed out of hand. In fact, the uncertainties about the timing, size, and particulars of the government's next "do-something" measure can only intensify the real fears that are immobilizing credit markets.

A meaningful response to our financial crisis will require a full understanding of the nature of the crisis and a willingness to follow through with institutional reforms. An essential part of those reforms should be based on a complete rethinking of the Federal Reserve's learning-by-doing strategy. The key issues here are (1) the Fed's ability--or inability--to pick the right interest rate target and (2) the appropriateness of relying on the unemployment rate and the inflation rate as the dominant indicators of the macroeconomic health of the economy.

The unemployment rate did not break out of the conventionally accepted 5-6 percent full employment band until August 2008 and the (year-over-year) inflation rate has stayed in the low-to-mid single digits. In ordinary times--or, at least, in times past--an unemployment and inflation scorecard like the one that characterized the Great Moderation could be displayed by the Federal Reserve with great pride. So dominant was this two-dimensional metric that one prominent economist (Phil Gramm) could look at the numbers in July 2008 and conclude, "We have become a nation of whiners." Whatever economic concerns had somehow provoked the whining, the economy seemed to him to be fundamentally sound.

A Brief Flashback to an Earlier Crisis

A rethinking of Federal Reserve policy during the Great Moderation can benefit from some reflection on earlier times. Many macroeconomists of my generation cut their teeth on the question of "rules versus discretion" as applied to monetary policy. In the 1970s, the central bank seemed to have a genuine choice between (1) adopting a money-growth rule, as suggested by Milton Friedman's monetarism, and (2) exercising discretion over interest rates, as prescribed by textbook Keynesianism. It could do one or the other but, of course, not both. The Fed had a firm grip on the supply of bank reserves, and almost as firm a grip on M1, the narrowest and most crisply defined monetary aggregate. In tranquil times, it could adjust reserves to get a desired change in the money supply or a desired change in short-term interest rates.

But tranquil times didn't last. The monetary crisis of the late 1970s was a game-changer. Under the guidance of Fed chairman G. William Miller, the discretionary changes in credit conditions had culminated in a steep uphill race between inflation and nominal interest rates, ending ultimately with negative real rates and a regime change in October 1979. During the early years of the Volcker Fed, interest-rate targeting was out and money-supply targeting was in. As was expected, both nominal and real interest rates rose to unprecedented heights during the monetary tightening. They eventually came back down but not before bringing market forces and interest-rate regulations into serious conflict. Market-clearing rates of interest were dramatically higher than banks were allowed to offer to depositors. The legislative response to this stalemate between markets and regulators was the Depository Institutions Deregulation and Monetary Control Act of 1980. DIDMCA phased out the Federal...