8
Figures 6 and 7 show the weakening of real GDP growth prior to cyclical peaks. Figures 8
and 9 fit a trend line to real personal consumption expenditures from peak to peak for a given cycle
and extend it through the subsequent recession (monthly data become available in 1959). (A single
trend line is fitted to the short 1980 recession and the 1981-82 recession.) As shown, consumption
weakened relative to trend prior to cyclical peaks. Figures 10 and 11 show the cyclical lag at peaks
in the decline in the real rate of interest.
8
Figure 12 shows the real rate series from Figure 11 and the
output gap measured by the Congressional Budget Office.
Standard Fed rhetoric is that because interest rates are at cyclical lows during recessions,
monetary policy is easy. However, the relevant characteristic of policy is the inertia the Fed imparts
to the funds rate prior to cyclical peaks while the economy weakens. Although Fed policymakers
never talk in terms of trade-offs, effectively at these times they were trying to create a negative
output gap in order to lower inflation.
Figures 13 and 14 organize a narrative account of Fed behavior.
9
Going into recessions,
inflation (the solid line) is at a cyclical high. Examination of FOMC transcripts shows that the
priority of the Fed at these times was to reduce inflation (Hetzel 2008, 2012, 2013a, 2013b; Romer
and Romer 1989). As a consequence, the Fed raised the funds rate until the economy weakened, as
illustrated by the way in which consumption fell below trend (dashed line). It then maintained a
cyclically high real rate (diamonds) in order to create a negative output gap. Over the course of the
recession, the real rate declined. With the exception of the recovery from the July 1981 to November
1982 cyclical contraction, during the economic recovery short-term real interest rates fell to zero.
However, by then it was too late to undo the effects of contractionary monetary policy.
The criteria used above in order to associate contractionary monetary policy with the onset of
recession provide causal substance to the common practice of using the yield curve as a predictor of
recession. As illustrated by Estrella and Trubin (2006), forecasters associate a flattening of the yield
curve with an increased probability of recession. While the Fed is raising short-term rates out of
concern for inflation, in response to a weakening economy, markets are lowering long-term rates.
Wright (2006) shows that a better predictor of recession is the combination of a flattening of the yield
curve and a cyclically high short-term interest rate, as is evident in Figures 10 and 11.
The validity of monetarist hypotheses depends upon the interpretation of the experiment in
the Volcker-Greenspan era of abandoning stop-go. In the Volcker-Greenspan era, the Fed
8
Figure 10 uses inflation forecasts from the Livingston survey, which is biannual and available after
1945. Figure 11 uses inflation forecasts contained in the Board of Governors staff document called
the Greenbook prepared for FOMC meetings. See “Appendix: Real Rate of Interest.”
9
An empirical Taylor-rule literature characterizes Fed behavior. In these regressions, the constant
term plus the output gap capture the cyclical behavior of short-term interest rates over the cycle while
the inflation term captures the relationship between trend inflation and short-term interest rates.
Because these regressions are reduced forms, two caveats arise. First, they only partially capture the
relevant structural reaction function used by the Fed. Second, to the extent that they do capture the
latter, there is no reason to believe they express optimal policy around cyclical peaks when the Fed
responds directly to inflation it considers too high (Hetzel, forthcoming).
9
accompanied its LAW procedures with communication to financial markets that changes in the funds
rate would cumulate to whatever extent required in order to maintain low, stable inflation. The
marker for the credibility of this commitment was the absence of inflation premia in bond rates.
10
The most dramatic tests of the Fed’s credibility in the Volcker-Greenspan era occurred as “inflation
scares” (Goodfriend 1993; Hetzel 2008, Ch. 14). The need to establish credibility with the “bond
market vigilantes” required rejection of the earlier stop-go policy of attempting to manipulate Phillips
curve relationships through trading off between an output gap and inflation (Goodfriend and King
2005).
Hetzel (2008) termed these latter procedures “LAW with credibility.” The evidence for
credibility became the condition that in response to “news” about the economy, say, that it was
growing more strongly than previously anticipated, the yield curve would move in a stabilizing way
with all of the movement in real forward rates and none in inflation premia (Hetzel, forthcoming).
When the Fed follows a rule such that it consistently sets its funds rate target based on a forecasted
path that will keep real output growing at potential, markets will forecast the pattern of forward rates
that will cause the yield curve to keep output growing at potential. In this way, the Fed constrains
itself to set the funds rate to track the natural rate of interest. Although LAW with credibility was not
a money growth rule, it was monetarist in spirit. The price system works in that financial markets
use information efficiently. The Friedman long-and-variable-lags critique applied to LAW
procedures implemented as stop-go. With LAW with credibility, the Fed was tracking the real rate
and thus giving free rein to market forces to determine real variables, not attempting to control the
real rate in order to manipulate an output gap.
11
5.
The NK model as a monetarist model
The monetarist stylized facts of Section 4 do not substitute for a model. With the NK model,
monetarists got a model. The benchmark for judging optimality became the real business cycle
(RBC) core of the NK model (Kydland-Prescott 1982). That core summarizes a competitive market
economy predicated on the assumption that the price system works well to assure full employment of
resources. Forward-looking households and firms with rational expectations process information
about the future efficiently (Kydland and Prescott 1977; Lucas 1980 [1981]). The monetarist
argument for a rule gained a theoretical foundation built on the way in which a rule conditions
expectations about future monetary policy to respond in a stabilizing way in response to “news”
about the economy. Those characteristics of the NK model challenged the Keynesian recourse to
animal spirits and periodic bouts of pessimism that presumably overwhelm the stabilizing properties
of the price system and the intertemporal consumption-smoothing property of the real interest rate.
10
After the Treasury-Fed Accord in 1951, these procedures began to evolve under William
McChesney Martin and Winfield Riefler. The Fed abandoned them initially in response to pressure
from the Johnson administration and later in the 1970s Burns-Miller era but returned to them in the
Volcker-Greenspan era (Hetzel 2008, Chs. 5-7 and 14-15).
11
In the Greenspan era, the minor recessions of 1990-91 and 2001 continue to exhibit the
combination of a weakening of the economy prior to cyclical peaks and persistent, cyclically high
real rates of interest. In the former, policy aimed at moving from 4 percent inflation to price stability.
The latter reflected a minor go-stop policy set off by the Asia crisis (Hetzel, Chs. 15 and 17).