Aftermath of the Monetarist Clash with the Federal Reserve Before and During the Volcker Era

Abstract

• Fed monetary policy is based on a nominal short-term interest rate, which is an unreliable guide. The Fed interprets a low rate as indicating monetary ease, a high rate as indicating monetary tightening. A low rate, however, may in fact be consistent with contraction if the growth rate of the quantity of money has been declining, and a high rate may be consistent with expansion if the growth rate of the quantity of money has been rising. Moreover, monetary authorities who rely on an interest rate instrument are prone to delay a needed increase to combat inflation because they believe that it will produce a rise in the unemployment rate. Action is often late and excessive. Prescription: Monetary policy should be based on a credible, pre-announced, longrun stable growth rate of a monetary aggregate, preferably the monetary base or M2. • The Fed instructs the Manager of open market operations at the Federal Reserve Bank of New York to maintain money market conditions that it specifies in its directive to him, with a proviso that credit does not unduly expand. The directive leaves open to the Manager the interpretation to be placed on money market conditions and therefore makes it impossible to hold him accountable for the open market operations that he chooses to execute. Prescription: The Fed should not conduct M onetarists 40 years ago had a double objective. They sought to persuade the economics profession that (i) monetary policy, not fiscal policy, was the key to economic stability and (ii) the control of inflation required limiting money balances, not incomes policies and wage controls. Monetarists also sought to persuade the Federal Reserve to alter the way it conducted monetary policy to conform to monetarist doctrines. In the three years (1979-82) under Volcker, disinflationary monetary policy, announced as being designed to contain growth in money aggregates, brought down the U.S. inflation rate from 10 percent to 4 percent. Since then the inflation rate has remarkably declined even more. A victory for monetarism? During the Volcker era monetarists did not think so. Missing from the retrospective on the Volcker era at the special conference held at the Federal Reserve Bank of St. Louis was a consideration of the complaints against the Federal Reserve expressed by monetarists. The conference papers celebrated Volcker’s achievement and deemed the changes in monetary theory and practice since his time as virtually unqualifiedly successful. I propose to review past monetarist strictures (Shadow Open Market Committee, 1974-1982) and ask whether current Federal Reserve practice provides a satisfactory response to them. Twenty-five years after the Volcker era, has the contest between the U.S. central bank and its critics been resolved?