The great train wreck of 1976-78

The Federal Reserve has been taken to task on a number of occasions for its failure to control inflation in the 1970s, 1976-78 in particular. But I had no idea how bad the Fed’s policymaking was during this period until I waded through the Records of Policy Actions (don’t ask why I was doing this). Reading the RPAs for 1977-78 is like watching the replay of a train wreck in slow motion.



The Record of Policy Actions is the Federal Reserve’s ex post account of the meetings of the Federal Open Market Committee – which is charged with conducting monetary policy – released a month or two after each meeting. It explains what actions the FOMC took at the meeting and summarizes the discussions that led to the actions. Today economists believe that a competent Fed will react aggressively to rising inflation (or even evidence of future increases in inflation, such as very strong GDP growth) by raising the federal funds rate or (the procedure used in the 1970s) reducing its target for money supply growth. The Fed won’t tell us what its targets for inflation and GDP growth are, but for most of the post-WWII period the Fed seems to have been uncomfortable with inflation exceeding around 3%; most observers in the 1970s would have agreed that real GDP growth over about 3-4% would be unsustainable over long periods and potentially inflationary. In the early 1980s, the Fed accepted double digit unemployment rates as the price it had to pay to get inflation under control. How did the Fed’s response to rising inflation in 1976-78 stack up against this standard? Here are some excerpts from the RPAs of 1976-78.



March 15-16, 1976 (most recent estimate of GDP growth – 6.5%; estimate of current rate of inflation – 5.0%): “During the discussion it was noted that the recovery in economic activity had remained orderly, that liquidity had improved, and that the outlook for activity was satisfactory – although inflation remained a problem. Against that background, Committee members indicated that they favored essentially no change in policy.”



November 16, 1976 (GDP 3.3%, inflation 6.1%): “...against the background of the recent rate of increase in prices and the rapid monetary growth in October, anything more than a slight easing [!] might be interpreted as a lessening of the Federal Reserve System’s concern about the continuing problem of inflation.”



March 15, 1977 (GDP 3.8%, inflation 5.2%): “...members of the Committee were in general agreement with the staff projection that real GNP would expand at a rapid rate in the second quarter of 1977... Several members expressed concern about the recent and prospective behavior of prices... over the past few months price increases had been relatively large for a number of commodities, and that the extent to which increases seemed to be spreading among industrial materials might well be intensifying upward pressures on prices of industrial products in general... At the conclusion of the discussion the Committee decided that growth in M-1 and M-2 over the March-April period at annual rates within ranges of 4 ½ to 8 ½ per cent and 7 to 11 percent, respectively, would be appropriate” [this is an increase of 2% in the upper range for M-1 growth and an increase of 1% in the upper range for M-2 growth].



June 21, 1977 (GDP 7.0%, inflation 6.5%): “...businessmen were reported to be deeply concerned about inflation.” [No changes in money supply targets made at this meeting.]



September 20, 1977 (GDP 5.3%, inflation 6.4%): “...[O]ne member observed [that] recent experience had shown that high unemployment did not greatly reduce the rate of inflation, and the staff projections did suggest persistence of both a rapid rate of inflation and a high rate of unemployment. To a few members, those prospects for unemployment and prices indicated that active public discussion of some form of incomes policy would be appropriate.” [Translation: it’s not our problem, it’s Carter’s problem!]



October 17-18, 1977 (GDP 5.0%, inflation 6.8%): “The judgment was expressed that the administration apparently was not being effective in pursuing its anti-inflation policy.” [Translation: see above.]



February 28, 1978 (GDP 4.4%, inflation 7.1%): “The comment was made that prospects for inflation had been inhibiting business decisions to invest in fixed capital, and it was suggested that an acceleration would adversely affect confidence and would dampen expansion in spending of other kinds.” [Translation: inflation is bad because it reduces GDP growth.] “...by lowering the upper limit of the [money supply growth] range, the Committee would be providing a further indication of its resolve to resist inflationary pressures and in the process perhaps help to provide some near-term support for the dollar”. [Translation: a modest tightening of monetary policy tells business and financial markets that the Fed is serious about controlling inflation, even if it doesn’t actually have a noticeable effect on inflation.]



March 21, 1978 (GDP 4.4%, inflation 7.1%): “Several members observed that inflation led to recession, and it was suggested that the greater the inflation, the worse the ensuing recession. For that reason, it was suggested, special emphasis should be given to the Committee’s long-standing objective of helping to resist inflationary pressures while simultaneously encouraging continued economic expansion.” [Translation: we’re still not willing to risk recession in order to fight inflation.] “It was noted that an effective program to reduce the rate of inflation had to extend beyond monetary policy.” [Translation: Carter’s problem again.]



April 18, 1978 (GDP 9.0%, inflation 7.7%): “Committee members in general were deeply concerned about price prospects. Views were expressed to the effect that people in both the public and private sectors appeared as yet not to be making the sorts of difficult decisions required to reduce the pace of the rise in prices; that expectations of a high rate of inflation seemed to be growing and, as a result, actions of businessmen and consumers might tend to make their expectations self-fulfilling; that the rate of increase in wage rates might well accelerate if prices rose at the projected rate or if the labor contract recently negotiated in the coal industry were viewed as a pattern-setter; and that individual efforts to profit from inflation could lead to some speculative activity. The comment was also made that in the past several weeks the public’s attention increasingly had been focused on the problem of inflation... [T]he Committee could most effectively demonstrate its adherence to its longer-run objective and lend support to the administration’s anti-inflation program by succeeding in holding monetary growth within the existing range” [Translation: again, it’s confidence that counts, not actual progress in reducing inflation.] “...[M]onetary policy could be no more than one element in an effective program to fight inflation.” [Translation: Carter’s problem.] “[T]he members were unanimous in favoring retention of the existing range for M-1.”



May 16, 1978 (GDP 9.0%, inflation 7.7%): “A few members observed that in these circumstances it would be desirable for growth in real output to diminish in the second half of this year toward a rate that could be sustained for the longer term.” [Light dawns – almost!] “Several reasons were advanced for pursuing a very cautious approach to any further firming at this time, including the fact that transitory influences had contributed to the April surve in M-1... a significant degree of firming of money market conditions had been achieved since the April meeting... the administration’s new tax proposals... were considerably less stimulative than earlier ones... further significant monetary firming at this time might risk provoking dislocations in financial markets that would contribute eventually to the onset of a downturn in economic activity... At the conclusion of the discussion the Committee decided that the ranges of tolerance for the annual rates of growth of M-1 and M-2 over the May-June period should be 3 to 8 and 4 to 9 percent, respectively.” [a half point reduction].



July 18, 1978 (GDP 3.3%, 7.4%): “All members of the Committee expected a continuation of a rapid rate of inflation... A few members observed that the chances of a decline in output during the period had increased... At the conclusion of its discussion the Committee decided to retain the existing ranges for the monetary aggregates.”



By the end of 1978 and into 1979, the Fed’s willingness to confront inflation, even at the cost of a slowdown in economic growth, appears to have strengthened. After the October 6, 1979 meeting, the Fed had clearly decided that a recession was an acceptable cost of reducing inflation. But what went on in 1976-78? A couple of tentative conclusions:



1. One theory is that the Fed mismeasured the economy’s potential rate of growth, and so continually underestimated the inflationary consequences of their actions. But it’s clear that the Fed was aware of and concerned about the rising rate of inflation throughout this period.

2. Another theory is that the Fed didn’t see inflation as a monetary problem, believing instead that fiscal or incomes policies should be used to control it. There are certainly hints in the RPAs that this was the case. But the Fed had used monetary policy in an attempt at controlling inflation as recently as 1974; what changed? And why did the FOMC in 1979, composed of essentially the same members as in 1976-78, decide to use monetary policy to attack inflation? Paul Volcker, Chair of the Fed starting in 1979, is more than anyone else responsible for the disinflationary policies of the 1980s; but throughout 1976-78, when he was on the FOMC as President of the New York Fed, he was almost always with the majority. I think the repeated statements by members of the FOMC that inflation was someone else’s problem was more a defense mechanism than a true indication of beliefs.

3. The evidence is most consistent with the theory that the Fed didn’t fight inflation because it lacked the political will or mandate to do so. That mandate did exist after 1979, and so that’s when the Fed acted.

4. Because it was unwilling to slow growth in order to fight inflation, the Fed adopted the theory that it could affect inflationary expectations (and therefore ultimately inflation) by signalling its intention to stick to pre-announced monetary targets, even if those targets were keeping the economy over-stimulated. Here’s where the Fed’s old-fashioned economic thinking hurt it; it wasn’t that the Fed believed there was a permanent tradeoff between inflation and unemployment, nor that it thought monetary policy did not cause inflation; it’s that the Fed did not understand the point made by rational expectations theorists, that expectations were guided by facts on the ground, not empty gestures.



Most economists believe the Fed has learned its lessons from the disaster of the 1970s, and that double digit inflation could not happen again. The lesson I get from the 1970s, however, is that the Fed’s ability to control inflation is determined primarily by the willingess to put up with recession on the part of the public, Congress, and the President. If oil goes to $100 a barrel, inflation spikes and recession looms, do any of those three institutions now have the will to put the fight against inflation first? I don’t know.