Taylor Rules and the Great Inflation: Lessons from the 1970s for the Road Ahead for the Fed

Abstract

Can U.S. monetary policy in the 1970s be described by a stabilizing Taylor rule with a two percent inflation target when policy is evaluated with real-time inflation and output gap data? If so, it is problematic to use the Taylor rule as a guide to good policy as the Federal Reserve implements its exit strategy from the extraordinary measures taken in 2008 and 2009 since the same policy produced the Great Inflation. Using economic research on the full employment level of unemployment and the natural rate of unemployment published between 1970 and 1977 to construct real-time output gap measures for the periods of peak unemployment, we find that the Federal Reserve did not follow a Taylor rule if appropriate measures are used. We estimate Taylor rules and find no evidence that monetary policy stabilized inflation, even allowing for changes in the inflation target. While monetary policy was stabilizing with respect to inflation forecasts, the forecasts systematically under-predicted inflation following the 1970s recessions and this does not constitute evidence of stabilizing policy. We also find that the Federal Reserve responded too strongly to negative output gaps. If the Federal Reserve stabilizes inflation and does not respond too strongly to the output gap as the recovery begins, the 2010s can be a period of good economic performance like the 1980s and 1990s rather than a repeat of the 1970s.