Volcker Disinflation Research Articles

Income inequality and monetary policy regimes

This paper reconsiders the possible effects of monetary policy on income inequality. Accounting for potential structural breaks in the relationship, we find that this relationship varies across time and reverses following the Volcker disinflation during the Great Moderation.

The rise of inflation targeting

AbstractThis paper discusses the interactions between politics and economic ideas leading to the adoption of inflation targeting in the United States. In the gold standard era, farmers' vulnerability to falling prices made price‐level stabilization a salient political and social concern. Economists of the progressive era honed in on price‐level stabilization as a key to promoting prosperity and social justice. Irving Fisher, in alliance with farm interests, helped members of Congress introduce price‐level stabilization bills that, while unsuccessful, introduced the possibility that a price‐level stabilization mandate might be a viable alternative to a gold standard. In the postwar years, the Great Inflation and Volcker disinflation set the stage for the rise of inflation targeting by highlighting the benefits of credibility, transparency, and expectations management. Tensions inherent in the implementation of inflation targeting—including its position in the “rules versus discretion” debate—have become more pronounced since the post‐COVID run‐up in inflation.

Inflation gap persistence, indeterminacy, and monetary policy

Empirical literature has documented that the persistence of the gap between inflation and its trend declined after the Volcker disinflation. Previous studies into the source of the decline in inflation gap persistence have offered competing views while sidestepping the possibility of equilibrium indeterminacy. We examine the source of the decline by estimating a medium-scale dynamic stochastic general equilibrium model using Bayesian methods that allow for indeterminacy. We show that the Fed's change from a passive to an active policy response to the inflation gap or a decrease in firms' probability of price change can fully account for the decline in inflation gap persistence by ruling out indeterminacy that induces persistent economic dynamics.

The first inflation problem of the twenty-first century

Inflation in the US after World War II peaked at 19.7 per cent in the 12 months to March 1947. The US economy reoriented itself from its wartime to its post-war structural configuration. The Federal Reserve did nothing at all. Inflation went negative in 1949 at the onset of a minor recession. Inflation revived in 1951, and was in some ways a reverse of 1947 – not a demobilization but a remobilization inflation. Again, the Federal Reserve did nothing. And, again, the inflation wave passed. Then came the long siege of moderate inflation that took place between 1966 and 1980, as the Federal Reserve dithered before the Volcker disinflation. What policy you think would have been and will be appropriate for the Biden Administration and the Yellen–Powell Fed depends on which of these past historical episodes provides the best model and analogy for the state of the US economy today. The odds right now seem to me to be on the first two, rather than the third.

Proxy SVAR identification of monetary policy shocks - Monte Carlo evidence and insights for the US

In empirical macroeconomics, proxy structural vector autoregressive models (SVARs) have become a prominent path towards detecting monetary policy (MP) shocks. However, in practice, the merits of proxy SVARs depend on the relevance and exogeneity of the instrumental information employed. Our Monte Carlo analysis sheds light on the performance of proxy SVARs under realistic scenarios of low relative signal strength attached to MP shocks and alternative assumptions on instrument accuracy. In an empirical application with US data we argue in favor of the specific informational content of instruments based on the dynamic stochastic general equilibrium model of Smets and Wouters (2007). A joint assessment of the benchmark proxy SVAR and the outcomes of a structural covariance change model implies that from 1973 until 1979 monetary policy contributed on average between 2.2 and 2.4 percent of annual inflation. For the so-called Volcker disinflation starting in 1979Q4, the benchmark structural model shows that the Fed’s policy measures effectively reduced the GDP deflator within three years (i.e. by -12.26 pp until 1982Q3).

Proxy SVAR Identification of Monetary Policy Shocks - Monte Carlo Evidence and Insights for the Us

In empirical macroeconomics, proxy structural vector autoregressive models (SVARs) have become a prominent path towards detecting monetary policy (MP) shocks. However, in practice, the merits of proxy SVARs depend on the relevance and exogeneity of the instrumental information employed. Our Monte Carlo analysis sheds light on the performance of proxy SVARs under realistic scenarios of low relative signal strength attached to MP shocks and alternative assumptions on instrument accuracy. In an empirical application with US data we argue in favor of the specific informational content of instruments based on the dynamic stochastic general equilibrium model of Smets andWouters (2007). A joint assessment of the benchmark proxy SVAR and the outcomes of a structural covariance change model imply that from 1973 until 1979 monetary policy contributed on average between 2.2 and 2.4 units of inflation in the GDP deflator. For the so-called Volcker disinflation starting in 1979Q4, the benchmark structural model shows that the Fed's policy measures effectively reduced the GDP deflator within three years (i.e. by -3.06 units until 1982Q3). While the empirical analysis largely conditions ona small-dimensional trinity SVAR, the benchmark proxy SVAR shocks remain remarkably robust within a six-dimensional factor-augmented model comprising rich information from Michael McCracken's database (FRED-QD).

Are Rising U.S. Interest Rates Destabilizing for Emerging Market Economies?

Rising U.S. interest rates are often thought to be bad news for emerging market economies (EMEs) as they increase debt burdens, trigger capital outflows, and generally cause a tightening of financial conditions that can lead to financial crises. Indeed, as shown in Figure 1 below, the rise in the federal funds rate (the black line) during the Volcker disinflation of the early 1980s was associated with a sharp rise in the incidence of financial crises in EMEs (the green bars).

Proxy SVAR Identification of Monetary Policy Shocks – Monte Carlo Evidence and Insights for the US

In empirical macroeconomics, proxy structural vector autoregressive models (SVARs) have become a prominent path towards detecting monetary policy (MP) shocks. However, in practice, the merits of proxy SVARs depend on the relevance and exogeneity of the instrumental information employed. Our Monte Carlo analysis sheds light on the performance of proxy SVARs under realistic scenarios of low relative signal strength attached to MP shocks and alternative assumptions on instrument accuracy. In an empirical application with US data we argue in favor of the specific informational content of instruments based on the dynamic stochastic general equilibrium model of Smets and Wouters (2007). A joint assessment of the benchmark proxy SVAR and the outcomes of a structural covariance change model imply that from 1973 until 1979 monetary policy contributed on average between 2.2 and 2.4 units of inflation in the GDP deflator. For the so-called Volcker disinflation starting in 1979Q4, the benchmark structural model shows that the Fed’s policy measures effectively reduced the GDP deflator within three years (i.e. by -3.06 units until 1982Q3). While the empirical analysis largely conditions on a small-dimensional trinity SVAR, the benchmark proxy SVAR shocks remain remarkably robust within a six-dimensional factor-augmented model comprising rich information from Michael McCracken’s database (FRED-QD).

Monetary Policy, Self-Fulfilling Expectations and the U.S. Business Cycle

I estimate a medium-scale New-Keynesian model and relax the conventional assumption that the central bank adopted an active monetary policy by pursuing inflation and output stability over the entire post-war period. Even after accounting for a rich structure, I find that monetary policy was passive prior to the Volcker disinflation. Sunspot shocks did not represent quantitatively relevant sources of volatility. By contrast, such passive interest rate policy accommodated fundamental productivity and cost shocks that de-anchored inflation expectations, propagated via self-fulfilling inflation expectations and constituted the primary sources of the run-up in inflation from the 1960s through the late 1970s.

Inflation and professional forecast dynamics: An evaluation of stickiness, persistence, and volatility

This paper studies the joint dynamics of U.S. inflation and a term structure of average inflation predictions taken from the Survey of Professional Forecasters (SPF). We estimate these joint dynamics by combining an unobserved components (UC) model of inflation and a sticky‐information forecast mechanism. The UC model decomposes inflation into trend and gap components, and innovations to trend and gap inflation are affected by stochastic volatility. A novelty of our model is to allow for time‐variation in inflation‐gap persistence as well as in the frequency of forecast updating under sticky information. The model is estimated with sequential Monte Carlo methods that include a particle learning filter and a Rao–Blackwellized particle smoother. Based on data from 1968 Q4 to 2018 Q3, estimates show that (i) longer horizon average SPF inflation predictions inform estimates of trend inflation; (ii) inflation gap persistence is countercyclical before the Volcker disinflation and acyclical afterwards; (iii) by 1990 sticky‐information inflation forecast updating is less frequent than it was earlier in the sample; and (iv) the drop in the frequency of the sticky‐information forecast updating occurs at the same time persistent shocks become less important for explaining movements in inflation. Our findings support the view that stickiness in survey forecasts is not invariant to the inflation process.

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The Taylor principles

We use tests for structural change to identify periods of low, positive, and negative Taylor rule deviations, the difference between the federal funds rate and the rate prescribed by the original Taylor rule. The tests define four monetary policy eras: a negative deviations era during the Great Inflation, a positive deviations era during the Volcker disinflation, a low deviations era during the Great Moderation, and another negative deviations era from 2001 to 2015. We then estimate Taylor rules for the different eras. The most important violations of the Taylor principles, the four elements that comprise the Taylor rule, are that the coefficient on inflation was too low during the Great Inflation and that the coefficient on the output gap was too low during the Volcker disinflation. We then analyze deviations from several alterations of the original Taylor rule. Between 2000 and 2007, Fed policy cannot be explained by any variant of the Taylor rule while, between 2007 and 2015, Fed policy is consistent with a rule where the federal funds rate does not respond at all to inflation and either responds very strongly to the output gap or incorporates a time-varying equilibrium real interest rate.

Variable Elasticity Demand and Inflation Persistence

We propose a novel explanation for the well-known persistent inflation response to monetary policy shocks by introducing variable elasticity demand curves in a staggered price model with trend inflation. The demand curves induce strategic complementarity in price setting and thus generate inflation persistence under positive trend inflation through the effect on inflation dynamics of a measure of price dispersion, which differs from relative price distortion. We also show that credible disinflation leads to a gradual decline in inflation a fall in output and that lower trend inflation reduces inflation persistence, as observed around the time of the Volcker disinflation.

Variable Elasticity Demand and Inflation Persistence

Persistent responses of inflation to monetary policy shocks have been difficult to explain by existing models of the monetary transmission mechanism without embedding controversial intrinsic inertia of inflation. Our paper addresses this issue using a staggered price model with trend inflation, a smoothed-off kink in demand curves, and a fixed cost of production. In this model, inflation exhibits a persistent response to a policy shock even in the absence of its intrinsic inertia, because the kink causes a measure of price dispersion, which is intrinsically inertial, to become a key source of inflation persistence under the positive trend inflation rate. {{p}} In addition, output and labor productivity both rise after an expansionary policy shock as in an estimated structural vector autoregression model. Moreover, credible disinflation induces a gradual decline in inflation and a fall in output as observed during the Volcker disinflation era.

Producer Price Inflation Connectedness and Input-Output Networks

We analyze the transmission of producer price inflation shocks across the U.S. manufacturing industries from 1947 to 2018 using the Diebold-Yilmaz Connectedness Index framework, which fully utilizes the information in generalized variance decompositions from vector autoregressions. The results show that the system-wide connectedness of the input-output network Granger-causes the producer price inflation connectedness across industries. The input-output network and the inflation connectedness nexus is stronger during periods of major supply-side shocks, such as the global oil and metal price hikes, and weaker during periods of aggregate demand shocks, such as the Volcker disinflation of 1981-84 and the Great Recession of 2008. These findings are consistent with Acemoglu et al. (2016)’s conjecture that supply shocks are transmitted downstream, whereas demand shocks are transmitted upstream. Finally, preliminary results show that Trump tariffs caused an increase in the system-wide inflation connectedness in the first half of 2018, due to shocks mostly transmitted from tariff-targeted industries, namely, basic metals, fabricated metals and machinery.

Policy credibility and alternative approaches to disinflation

This paper examines how central bank credibility affects the merits of a “gradualist” versus “cold turkey” approach to disinflation in a DSGE model in which private agents use optimal filtering to infer the central bank’s nominal anchor. Our analysis is applied to two episodes of sharp and deliberate monetary tightening in the United States – the post-WWI deflation and the Volcker disinflation. For a policy regime with relatively high credibility, our analysis highlights the benefits of a gradualist approach; thus, the aggressive tightening that occurred in 1920–21 did not seem warranted. In contrast, for a policy regime with relatively low credibility (such as the Federal Reserve in late 1980), an aggressive policy stance can play an important signalling role by making the policy shift more evident to private agents.

MONETARY POLICY RULES UNDER HETEROGENEOUS INFLATION EXPECTATIONS

This paper evaluates the role of inflation‐forecast heterogeneity in U.S. monetary policymaking. The deviation between private and central bank inflation forecasts is identified as a significant explanatory factor behind the Fed's monetary policy decisions. A discretionary policy rule that includes the forecast deviation as an additional argument is estimated empirically for the period 1975–2009, covering the chairmanships of Arthur Burns, George Miller, Paul Volcker, Alan Greenspan, and the beginning of Ben Bernanke's term, by using inflation forecasts obtained from the Federal Open Market Committee's Greenbook and the Survey of Professional Forecasters and real‐time estimates of the output gap. The estimated rule appears to provide a consistent description of the Fed's policy during the sample period presenting an alternative perspective regarding the key drivers of the high‐inflation phase in the 1970s as well as of the successful Volcker disinflation in the early 1980s and the gradual transition to a regime of lower inflation and high policy credibility that has increasingly characterized monetary policy over the past two decades. (JEL E50, E52, E58)

US inflation and output since the 1970s: a P-star approach

US inflation and output developments since the 1970s are considered using the P-star model and the VAR-based Diebold–Yilmaz spillover index approach. Shocks to monetary variables explain a substantial share of US GDP deflator inflation shocks over time, particularly in the late 1980s and early 1990s but also in recent years, a time when quantitative easing was employed by the Federal Reserve. Monetary factors, and not oil shocks, underlie price developments in the 1970s and early 1980s. Monetary shocks’ influence on oil prices has become noticeably stronger over the past ten years or so, supporting the greater attention being paid of late to the impact of the monetary environment on commodity markets. Shocks to the velocity-of-money variable affect output developments, with the exception of the 1970s and early 1980s when inflation shocks and, to a lesser extent, oil inflation shocks dominate the cross-variance share of output gap shocks. After the Volcker disinflation, the influence of both inflation and oil price shocks on the output gap wane and those of velocity gap shocks increase.

Puzzling Global Stochastic Trends in Growth, Interest and Inflation and the Volcker Disinflation

This paper aims to identify the stable long‐run relationships as well as unstable driving forces of the world economy using a small aggregated cointegrated VAR model encompassing quarterly US, UK, Japanese and Euro Area data for the post‐Bretton‐Woods era. Three stable long‐run relationships are found: output growth, the term spread and the inflation climate. The common stochastic trend of the global macro economy is dominated by the cumulated real short‐term interest rate shocks, reflecting the strong increase of global real rates during the Volcker disinflation period, one of the dominating events of the last 40 years of macro history.

Estimation and Solution of Models with Expectations and Structural Changes

SummaryIn this paper, we develop solutions for linearized models with forward‐looking expectations and structural changes under a variety of assumptions regarding agents' beliefs about those structural changes. For each solution, we show how its associated likelihood function can be constructed by using a ‘backward–forward’ algorithm. We illustrate the techniques with two examples. The first considers an inflationary program in which beliefs about the inflation target evolve differently from the inflation target itself, and the second applies the techniques to estimate a new Keynesian model through the Volcker disinflation. We compare our methodology with the alternative in which structural change is captured by switching between regimes via a Markov switching process. We show that our method can produce accurate results much faster than the Markov switching method as well as being easily adapted to handle beliefs departing from reality. Copyright © 2016 John Wiley & Sons, Ltd.