Paul Volcker Research Articles

Past and Future of Central Bank Cooperation: Policy Panel Discussion

On 27-29 June 2005, the BIS held its fourth Annual Conference on Past and Future of Central Bank Cooperation, as part of the Bank's 75th anniversary celebrations. The event brought together some 80 senior representatives of central banks, academic institutions and the private sector to exchange views on this topic. The conference was opened with addresses by Tommaso Padoa-Schioppa (former member of the Executive Board, ECB) and William White (Economic Adviser, BIS). It was closed with a Policy Panel discussion: Reflections on the future of central bank cooperation. The panel discussion was chaired by the BIS General Manager Malcolm D Knight. The panellists were Andrew D Crockett (JP Morgan Chase), Jacques de Larosiere (Paribas), Allan Meltzer (Carnegie Mellon University), Paul Volcker (International Accounting Standards Committee), and Yutaka Yamaguchi (former Deputy Governor, Bank of Japan). Their contributions are contained in this BIS Paper.

The incredible Volcker disinflation

The reduction in inflation that occurred in the early 1980s, when the Federal Reserve was headed by Paul Volcker, is arguably the most widely discussed and visible macroeconomic event of the last 50 years of U.S. history. Inflation had been dramatically rising, but under Volcker, the Fed first contained and then reversed this process. Using a simple modern macroeconomic model, we argue that the real effects of the Volcker disinflation were mainly due to its imperfect credibility. In our view, the observed upward volatility and subsequent stubborn elevation of long-term interest rates during the disinflation are key indicators of that imperfect credibility. Studying transcripts of the Federal Open Market Committee recently released to the public, we find—to our surprise—that Volcker and other FOMC members likewise regarded the long-term interest rates as indicative of inflation expectations and of the credibility of their disinflationary policy. Drawing from the transcripts and other contemporary sources, we consider the interplay of monetary targets, operating procedures, and credibility during the Volcker disinflation.

At the Global Crossroads: The Sylvia Ostry Foundation Lectures

AT THE GLOBAL CROSSROADS The Sylvia Ostry Foundation Lectures Sadako Ogata et al. Montreal & Kingston: Institute for Research on Public Policy/McGill-Queen's University Press, 2003. xiv, 105pp, $55.00 cloth (ISBN 0-7735-2637-4), $24.95 paper (ISBN 0-7735-2732-X)The first six lectures sponsored by Sylvia Ostry Foundation are included in this book, which is a fitting tribute to Ostry's outstanding career as a public servant, scholar, and international economic policy specialist. The contributors have knowledge and experience to provide valuable overviews of global economic, political, and social issues in 19905. They include Sadako Ogata, UN high commissioner for refugees from 1990 to 2000; Jacques Delors, president of European Commission from 1985 to 1995; Michel Camdessus, managing director of International Monetary Fund (IMF) from 1987 to 2000; Renato Ruggiero, director general of World Trade Organization (WTO) from 1995 to 1999; Enrique Iglesias, president of Inter-American Development Bank from 1988 to present; and Paul Volcker, chair of US Federal Reserve board of governors from 1979 to 1987.These lectures were given from 1993 to 2002, and it is inevitable that year of delivery affected focus and outlook. For example, 1994 Delors lecture was prompted by Europe's recession at time, and Ruggiero referred to the death of North-South in his 1996 lecture shortly after successful conclusion of GATT Uruguay Round (59). In years since Ruggiero's lecture, north-south divide has clearly re-emerged in WTO Doha Round. Although introduction to volume provides useful summaries of talks, it does not discuss context in which each lecture was written, and does not examine whether diverse lecture topics have some underlying themes. This is unfortunate, because certain common themes do emerge from this important group of lectures. The rest of this review refers to these themes.First, lectures examine degree to which globalization has blurred division between domestic and international affairs. Ogata discusses problem of protecting millions of internally displaced persons: people who are displaced by conflicts but who remain in their own countries. In addressing this problem, UN must weigh sensitivities of national sovereignty against concerns about human rights and threats to international peace and security. Ruggiero states that in making trade policy, governments must cooperate in more areas than in past. Some of distinctions we used to make between international policy and domestic policy look increasingly facile and irrelevant (51). …

Panel Discussion I: What Have We Learned Since October 1979?

Moderation.” Recessions have become less frequent and milder, and quarter-to-quarter volatility in output and employment has declined significantly as well. The sources of the Great Moderation remain somewhat controversial, but, as I have argued elsewhere, there is evidence for the view that improved control of inflation has contributed in important measure to this welcome change in the economy (Bernanke, 2004). Paul Volcker and his colleagues on the Federal Open Market Committee deserve enormous credit both for recognizing the crucial importance of achieving low and stable inflation and for the courage and perseverance with which they tackled America’s critical inflation problem. I could say much more about Volcker’s achievement and its lasting benefits, but I am sure that many other speakers will cover that ground. Instead, in my remaining time, I will focus on some lessons that economists have drawn from the Volcker regime regarding the importance of credibility in central banking and how that credibility can be obtained. As usual, the views I will express are my own and are not necessarily shared by my colleagues in the Federal Reserve System. Volcker could not have accomplished what he did, of course, had he not been appointed to the chairmanship by President Jimmy Carter. In retrospect, however, Carter’s appointment decision seems at least a bit incongruous. Why would the President appoint as head of the central bank an individual whose economic views and policy goals (not to mention personal style) seemed, at least on the surface, quite different from his own? However, not long into Volcker’s term, a staff economist at the Board of Governors produced a paper that explained why Carter’s decision may in What Have We Learned Since October 1979?

Chairman's Remarks

In his remarks at the conference, the Chairman of the Federal Reserve notes that the policy change initiated under the leadership of Chairman Paul Volcker rescued our nation’s economy from a dangerous path of ever-escalating inflation and instability.

Inflation, Presidents, Fed Chairs, and Regime Shifts in the U.S. Real Interest Rate

Several recent papers agree on the existence of significant regime shifts in the U.S. real interest rate, but disagree on the proximate causes of the shifts. Caporale and Grier (2000) point to large political changes as correlates, while Rapach and Wohar (2004) show that real rate breaks are correlated with inflation regime shifts and argue that the inflation regime changes cause the real rate shifts. In this paper we show that, controlling for the timing of changes in the inflation regime, dummy variables representing either party change in the Presidency or change in the identity of the Fed Chair are still strongly significant for explaining real interest rate fluctuations. When we control for a fixed coefficient linear relationship between inflation and the real rate, we find two real rate regime shifts that line up almost exactly with the accessions of Paul Volcker and Alan Greenspan. Even if we first let inflation regime switches explain the real rate and then look for regime shifts in the residuals, we find almost exactly the same two breaks. These results imply that Fed Chairs sometimes differ with respect to their preferred equilibrium real interest rate.

The Monetary Policy Debate Since October 1979: Lessons for Theory and Practice

Monetary theory and policy have been revolutionized in the two decades since October 1979, when the Federal Reserve under the leadership of Paul Volcker moved to stabilize inflation and bring it down. On the side of practice, the decisive factor was the demonstration that monetary policy could acquire and maintain credibility for low inflation, and improve the stability of both inflation and output relative to potential.

The International Implications of October 1979: Toward a Long Boom on a Global Scale

It is difficult today to appreciate how desperate the economic situation had become 25 years ago. It is difficult because the United States has enjoyed a prolonged period—a long boom—of low inflation and long economic expansions since the early 1980s. But by 1979, inflation had moved up to a double-digit pace and threatened to spiral higher. The economy was showing signs of weakness, and many were predicting recession and rising unemployment. The mood in financial markets was becoming one of deep gloom, as the dollar was sinking and interest rates were soaring. Surveys showed that inflation expectations were climbing to unprecedented double-digit levels, and public opinion polls were consistently indicating that inflation was the number one worry. Needless to say, confidence in U.S. macroeconomic management had been plunging both at home and abroad and had no doubt fallen to a post-World War II low. For its part, the Federal Reserve had been setting ranges for money growth that it thought to be consistent with bringing inflation down. However, it had been overshooting or pressing the upper limits of those ranges regularly. To many observers, the Fed’s difficulty in keeping the monetary aggregates within the announced ranges were owed to its operating procedures, which involved actions to move the federal funds rate that were too little and too late, leaving the Fed behind the curve. On August 6, 1979, a new Chairman of the Fed—Paul Volcker—took office. At first, the arrival of Volcker came as a relief to market participants. Through his public record and statements, Paul Iam pleased and honored to be here to share my thoughts on the momentous event that occurred on October 6, 1979, and I thank Bill Poole, Bob Rasche, and Dan Thornton for being such gracious hosts. I will argue tonight that the masterful decisions made that day represented a critical first step in reasserting American leadership in economic policy around the world. This leadership, which continues today, has benefited not only the United States but also the entire international community. It has brought forth policies that have increased price stability, lessened fluctuations in output and employment, and promoted longer, more sustained economic expansions around the globe while restoring the dollar as a stable reserve currency. Anyone who was more than just a casual observer of economic policymaking at the time realized that the measures announced on October 6 represented a major change in the conduct of monetary policy. If pursued to their conclusion, the measures would break the back of a vicious cycle of accelerating prices. If translated into new lasting principles of monetary policy, the specific measures would represent a true “regime” change. However, armed with monetary policy models that incorporated both inflation momentum and rational expectations, I also realized that tighter control of money was going to be associated with considerable economic strain for a period of time— not as bad or as long-lasting a strain as some pessimists had predicted, but a severe strain nonetheless. This would require exceptional fortitude by the Federal Reserve and broad support from elsewhere in the government.

Inferring Policy Objectives from Economic Outcomes*

AbstractEstimated policy rules are reduced‐form equations that are silent on many important policy questions. However, a structural understanding of monetary policy can be obtained by estimating a policymaker's objective function. The paper derives conditions under which the parameters in a policymaker's policy objective function can be identified and estimated. We apply these conditions to a New Keynesian sticky‐price model of the US economy. The results show that the implicit inflation target and the relative weight placed on interest rate smoothing both declined when Paul Volcker was appointed Federal Reserve chairman.

Shocks and Government Beliefs: The Rise and Fall of American Inflation

We use a Bayesian Markov Chain Monte Carlo algorithm to estimate the parameters of a “true” data-generating mechanism and those of a sequence of approximating models that a monetary authority uses to guide its decisions. Gaps between a true expectational Phillips curve and the monetary authority's approximating nonexpectational Phillips curve models unleash inflation that a monetary authority that knows the true model would avoid. A sequence of dynamic programming problems implies that the monetary authority's inflation target evolves as its estimated Phillips curve moves. Our estimates attribute the rise and fall of post-WWII inflation in the United States to an intricate interaction between the monetary authority's beliefs and economic shocks. Shocks in the 1970s made the monetary authority perceive a tradeoff between inflation and unemployment which ignited big inflation. The monetary authority's beliefs about the Phillips curve changed in ways that account for former Federal Reserve Chairman Paul Volcker's conquest of U.S. inflation.

Risk and Uncertainty in Monetary Policy

I plan to sketch the key developments of the past decade and a half of monetary policy in the United States from the perspective of someone who has been in the policy trenches. I will offer some conclusions about what I believe has been learned thus far, though I suspect, as is so often the case, the passing of time, further study, and reflection will deepen our understanding of these developments. This is a personal statement; I am not speaking for my current colleagues on the Federal Open Market Committee (FOMC) or the many others with whom I have served over these many years. The tightening of monetary policy by the Federal Reserve in 1979, then led by my predecessor Paul Volcker, ultimately broke the back of price acceleration in the United States, ushering in a two-decade long decline in inflation that eventually brought us to the current state of price stability. The fall in inflation over this period has been global in scope, and arguably beyond the expectations of even the most optimistic inflationfighters. I have little doubt that an unrelenting focus of monetary policy on achieving price stability has been the principal contributor to disinflation. Indeed, the notion, advanced by Milton Friedman more than 30 years ago, that inflation is everywhere and always a monetary phenomenon, is no longer a controversial proposition in the profession. But the size and geographic extent of the decline in inflation raises the question of whether other forces have been at work as well. I am increasingly of the view that, at a minimum, monetary policy in the last two decades has been operating in an environment particularly conducive to the pursuit of price stability. The principal features of this environment included (i) increased political support for stable prices, which was the consequence of, and reaction to, the unprecedented peacetime inflation in the 1970’s, (ii) globalization, which unleashed powerful new forces of competition, and (iii) an acceleration of productivity, which at least for a time held down cost pressures. I believe we at the Fed, to our credit, did gradually come to recognize the structural economic changes that we were living through and accordingly altered our understanding of the key parameters of the economic system and our policy stance. The central banks of other industrialized countries have grappled with many of the same issues. But as we lived through it, there was much uncertainty about the evolving structure of the economy and about the influence of monetary policy. Despite those uncertainties, the trauma of the 1970’s was still so vivid throughout the 1980’s that preventing a return to accelerating prices was the unvarying focus of our efforts during those years. In recognition of the lag in monetary policy’s impact on economic activity, a preemptive response to the potential for building inflationary pressures was made an important feature of policy. As a consequence, this approach elevated forecasting to an even more prominent place in policy deliberations. After an almost uninterrupted stint of easing from the summer of 1984 through the spring of 1987, the Fed again began to lean against increasing inflationary pressures, which were in part the indirect result of rapidly rising stock prices. We had recognized the risk of an adverse reaction in a stock market that had recently experienced a steep run-up—indeed, we actively engaged in contingency planning against that possibility. * Board of Governors of the Federal Reserve System, 20th Street and Constitution Avenue, N.W., Washington, DC 20551. 1 I, nonetheless, wish to thank my colleagues David Stockton, David Wilcox, Don Kohn, Ben Bernanke, and John Taylor, for their many suggestions and reminiscences.

Monetary Policy Rules, Macroeconomic Stability, and Inflation: A View from the Trenches

I estimate a forward-looking monetary policy reaction function for the Federal Reserve for the periods before and after Paul Volcker’s appointment as Chairman in 1979, using information that was available to the FOMC in real time from 1966 to 1995. The results suggest broad similarities in policy and point to a forward-looking approach to policy consistent with a strong reaction to inflation forecasts during both periods. This contradicts the hypothesis, based on analysis with ex post constructed data, that the instability of the Great Inflation was the result of weak FOMC policy responses to expected inflation. A difference is that prior to Volcker’s appointment, policy was too activist in reacting to perceived output gaps that retrospectively proved overambitious. Drawing on contemporaneous accounts of FOMC policy, I discuss the implications of the findings for alternative explanations of the Great Inflation and the improvement in macroeconomic stability since then.

Speaking Historically about Globalization and Related Fantasies

January 2004 · Historically Speaking23 administrationwere fundamentally different from the policies followed byNazi Germany, to say nothing of the Five Year Plans of the Soviet Union. Moreover, Lindsey's dating of the turn in U.S. policy away from centralized , top-down control back toward markets between 1945 and 1947 is inaccurate. I would suggestthatthe decisive change actuallycame with Ronald Reagan and Paul Volcker forty years later. Strikingly, Lindseynever discusses the turnaround in Britain, omitting anymention ofMargaret Thatcher. The key point here is that the U.S. and Britain were different in fundamental ways fromNazi Germany and the Soviet Union. Both had democratic political systems and legal structures that limited the powers of the executive, legislative, and judicial authorities and protected private property. None oftheir totalitarian contemporaries had similar safeguards. Moreover, the populations ofthe two democracies had internalized democratic competitive values. Theyknewthe rules ofthe marketgame. The people of Germany and Russia had never known these things. Consequendy, the balanced Western systems were able to withstand the shocks ofdepression and war. They made some compromises, but ultimately remained true to their traditions. These fundamental factors—limited government, democracy, a legal framework for economic activity, and private property—distinguished the Western democracies from the dictatorships , whatever the similarities they mayhave had in their administrative structures. Ironically , Hayekemphasized these important factors in his later works.4 One size does not fit all. Ramming diverse historical examples into an otherwise serviceable theory obscures rather than clarifies. A more nuanced approach would be much more effective. Surely, countries like Britain and the United States should be placed in a separate category from Nazi Germany and Stalin's Soviet Union. While I agree with much ofwhat Lindsey has to say, it seems to me that his analysis deserves criticism on two grounds, one historical and one logical. The historical roots of centralized, top-down control are deeper and more varied than Lindsey thinks. Grouping together differentregimes because theyshare some administrative methods confuses matters . As Ludwig Erhard pointed out, economies are not ends in themselves. Alfred C. Mierzejewski isan associateprofessor ofhistory at the University ofNorth Texas. He is the author o/The Most Valuable Asset ofthe Reich: AHistory ofthe German National Railway, 1920-1945, two volumes, (University ofNorth Carolina Press, 1999, 2000). 1 Of Hayek's many works I will only recommend the following: The Road to Serfdom (University of Chicago Press, 1944); Individualism and Economic Order (University ofChicago Press, 1948); Capitalism and the Historians (University of Chicago Press, 1954). I would also suggest three books about Hayek: Alan Ebenstein, Friedrich Hayek: A Biography (Palgrave, 2001); G.R. Steele, The Economics ofFriedrich Hayek (St. Martin's, 1993) and Eamonn Butler, Hayek: His Contribution to thePolitical and Economic Thought ofOur Time (Temple Smith, 1983). 2 Ralph Raico, Die Partei derFreiheit, translated by Jörg Guido Hülsmann, Gabriele Bartel, and Pia Hess (Lucius & Lucius, 1999); Dieter Langewiesche , Liberalism in Germany (Princeton University Press, 2000); andJamesJ. Sheehan, German Liberalism in theNineteenth Century (Universityof Chicago Press, 1978). 3 Sally Marks, Illusion ofPeace: International Relations in Europe, 1918-1933 (St. Martin's, 1976); Stephen A. Schuker,American Reparations to Germany , 1919-1933: Implicationsforthe Third World Debt Crisis (International Finance Section, Department ofEconomics, 1988); and, presenting a very different view, Bruce Kent, The Spoils ofWar: The Politics, Economics, and Diplomacy ofReparations, 1918-1932 (Clarendon Press, 1989). 4 Friedrich A von Hayek, Law, Legislation, andLiberty , 3 vols. (University of Chicago Press, 1973, 1976, 1979). Speaking Historically about Globalization and Related Fantasies Liah Greenfeld History, says Marc Bloch, is the "science of men in time." When one talks ofhistory, even in the non-specialist press, it is useful to mention (or not to mention, depending on the aimed-at result) dates. It is also useful—according to Bloch, absolutely essential—to provide precise definitions ofthe historical phenomena one talks about. Ifone makes historical claims and yet does notmention dates and skimps on definitions , one abuses history and misrepresents it (i.e., presents it forwhat it is most assuredly not: a mixed bag ofarguablyreal butperhaps imaginary events or non-events which either happened or did not happen at one time or another). One thing certain about arguments presented in such a dateless and undefined manner is...

Rentier Incomes and Financial Crises: An Empirical Examination of Trends and Cycles in Some OECD Countries

We present new estimates of the rentier share of national income for OECD countries for the years between 1960 and 2000. For most countries, the rentier share of income significantly increased during the last several decades, starting in the early 1980's and coinciding with the shift to neo-liberal monetary and financial policies initiated by Margaret Thatcher and Paul Volcker. There is no evidence of a negative correlation between rentier shares and non-financial corporate shares of income. However, rentier shares do decline in those semi-industrialized countries that experienced financial crises. These findings are consistent with the view that financial liberalization has been associated with the increased power of an international rentier class, whose interests are aligned with those of non-financial corporations in the richer countries, but whose interests conflict with rentiers in developing countries that experience financial crises.

Rentier Incomes and Financial Crises: An Empirical Examination of Trends and Cycles in Some OECD Countries

We present new estimates of the rentier share of national income for OECD countries for the years between 1960 and 2000. For most countries, the rentier share of income increased significantly during the last several decades, starting in the early 1980s and coinciding with the shift to neo-liberal monetary and financial policies initiated by Margaret Thatcher and Paul Volcker. There is no evidence of a negative correlation between rentier shares and non-financial corporate shares of income. However, rentier shares do decline in those semi-industrialized countries that experienced financial crises. These findings are consistent with the view that financial liberalization has been associated with the increased power of an international rentier class, whose interests are aligned with those of non-financial corporations in the richer countries, but whose interests conflict with rentiers in developing countries that experience financial crises.

There are Many Alternatives: Margaret Thatcher in the History of Economic Thought

The last twenty-five years of the twentieth century were freighted with important moments for historians of economic thought: the collapse of the Keynesian consensus, the rise (and fall) of monetarism, the collapse of the former Soviet Union and the other Marxist-Leninist states in central and eastern Europe, the rise of neo-liberalism, and arguments over the possible emergence of a “New Economy” following the internet investment boom at the end of the 1990s. Each of these moments will require its own history as we slowly move away from the tumult of the times and begin to weigh them for their own significance. But several of the moments have a common iconic face in Margaret Thatcher, the Prime Minister of Great Britain from 1979 to 1990. Few other individuals so readily embody the sense of the times. Thatcher's election—a full year and a half before Ronald Reagan's—marks for many people the moment when Keynesian policies finally and irretrievably lost their legitimacy. Likewise, the timing of her election, just two months before Paul Volcker's selection as the chair of the Federal Reserve Board of Governors in the United States, also means that for many people Thatcher's is the public face of monetarism's ascendancy. Finally, there is probably no one person whose name is so clearly associated with the rise of free market thinking and neo-liberalism during the end of the twentieth century.

Price stability vs. output stability: tales of federal reserve administrations

This study disentangles policy parameters from those describing private sector behavior by simultaneously estimating an empirical model for inflation and output along with a loss function for the last three Federal Reserve administrations. Three important results emerge: First, the Federal Reserve appears to put more emphasis on price stability than output stability when the entire sample is considered. Second, and more importantly, the loss function parameters exhibit structural break at the time Paul Volcker was appointed chairman. The accommodative characteristics of monetary policy were replaced with a more active policy towards controlling inflation. Finally, interest rate smoothing is found to be an important feature of the monetary policymaking process for all three administrations.

Monetary Policy Rules, Macroeconomic Stability and Inflation: A View from the Trenches

I estimate a forward-looking monetary policy reaction function for the Federal Reserve for the periods before and after Paul Volcker's appointment as Chairman in 1979, using information that was available to the FOMC in real time from 1966 to 1995. The results suggest broad similarities in policy and point to a forward looking approach to policy consistent with a strong reaction to inflation forecasts during both periods. This contradicts the hypothesis, based on analysis with ex post constructed data, that the instability of the Great Inflation was the result of weak FOMC policy responses to expected inflation. A difference is that prior to Volcker's appointment, policy was too activist in reacting to perceived output gaps that retrospectively proved overambitious. Drawing on contemporaneous accounts of FOMC policy, I discuss the implications of the findings for alternative explanations of the Great Inflation and the improvement in macroeconomic stability since then.

Analyzing Fed behavior using a dynamic Taylor-type rule

This paper estimates a dynamic Taylor-type model in order to analyze the behavior of the Federal Reserve under the leadership of three different Fed chairs: Arthur Burns, Paul Volcker, and Alan Greenspan. The model proves useful in distinguishing the conduct of monetary policy under each. Burns is found to have paid little attention to inflation and inflationary pressures. Volcker focused on reducing actual inflation during his first term while turning his attention to the GDP gap and inflationary pressures in his second term. Greenspan emphasized preemptive strikes against inflation as indicated by high weights attributed to the GDP gap and expected inflation.

Noise Trading and Exchange Rate Regimes

Policy-makers often justify their choice of fixed exchange rate regimes as a shelter against nonfundamental influences in the foreign exchange market. This paper proposes a framework, based on endogenous noise trading, which makes sense of the policy-makers' view. We show that as a result of multiple equilibria, the model violates Mundell's Incompatible Trinity: under some conditions, it is possible to reduce the volatility of the exchange rate without any sacrifice in terms of monetary autonomy. We provide empirical evidence supportive of the existence of a nonfundamental channel in the link between exchange rate regimes and exchange rate volatility. If … markets come to believe exchange rate stability is not itself a significant policy objective, we should not be surprised that snowballing cumulative movements can develop that appear widely out of keeping with current balance-of-payments prospects or domestic price movements. At that point, freely floating exchange rates, instead of delivering on the promise of money autonomy for domestic monetary or other policies, can greatly complicate domestic economic management [Paul Volcker 1978–79, p. 9].