Understanding inflation: lessons from my central banking career; the main lesson is that inflation is still a mystery

Business Economics, Jan, 2003 by Harvey Rosenblum

Ironically, the ideas I espoused were not new and had a long and distinguished pedigree. Indeed, these ideas had been enunciated very clearly just a few years earlier in Milton Friedman's Presidential Address to the American Economic Association. Friedman (1968) was succinct: "Inflation is always and everywhere a monetary phenomenon."

It was adherence to this belief that induced then Federal Reserve Chairman Paul A. Volcker and the Federal Open Market Committee (FOMC) on October 6, 1979, to abandon conducting monetary policy by setting the federal funds rate and to instead focus more directly on controlling the growth rate of money. In part because extreme volatility of interest rates accompanied monetary targeting, and in part because inflation had become more muted, the FOMC's experiment with rigid monetary control ended three years after it began.

Although the inflation rate dropped from double-digit levels in the late 1970s and early 1980s, it rarely fell below the three percent to four percent range. The Fed finally abandoned monetary targeting altogether in mid-1993. The FOMC announced its downgrading of M2 and M1 as intermediate targets because it recognized, in the words of Fed Chairman Alan Greenspan, "that the relationship between spending and money holdings was departing markedly from historical norms.... The FOMC would continue to monitor the behavior of money-supply measures, but it would base its policy actions on a wide variety of economic indicators." In other words, the Fed was abandoning the monetary aggregates because their behavior, at least in the short run, had abandoned us.

In spite of these problems, inflation was well-contained. The inflation experience of the 1990s can be seen in Figure 1. The latest research findings suggest not that money growth doesn't matter, but that it matters over much longer horizons. Work by the Cleveland Fed concludes that "a relatively close relationship between money growth and inflation may exist over eight-year time horizons, at least for the broader monetary aggregates." In other words, money growth is not a particularly useful guide for short-term monetary policy decisions, but long-run inflation trends are significantly influenced by the long-run growth rate of the money supply. However, recent studies convince me that the definition of "the long run" keeps getting longer, and longer.

The Phillips Curve and Related Concepts

Economists are well known for airing and discussing their differences in public. This has given the economics profession a reputation for never agreeing on much of anything. Nothing could be further from the truth. Economists agree on a great deal and their points of agreement fill the best-selling textbooks in principles of economics, most of which have expanded by a couple of hundred pages over the last decade or so. Can we infer that economists agree on more than they used to? Probably not!

It is a rare text that doesn't spend a dozen or more pages on the Phillips Curve and its cousins, the NAIRU (the non-accelerating inflation rate of unemployment) and the natural rate of unemployment (for short, the natural rate). Until about 1995, the Phillips Curve, which depicted a negative association or tradeoff between inflation and unemployment, generally looked as it was supposed to, though it did tend to shift roughly once a decade. This can be seen in Figure 2. A line fitting the points labeled "1961-70" is the Phillips Curve that prevailed when I studied undergraduate and graduate economics in the 1960s. Following President Nixon's experiment with price and wage controls in 1971-73, the Phillips Curve relationship shifted in 1974; and over the next decade, U.S. policymakers were confronted with a Phillips Curve array that offered choices that by today's standards would be labeled "bad" and "worse."