Has it been a disaster or a success?
Yesterday marked the third anniversary of a dramatic change in the Federal Reserve's conduct of monetary policy. Since that change was effected on Oct. 6, 1979, inflation has slowed sharply -- much more sharply than most people predicted -- and the Federal Reserve has been much more successful at controlling money growth than it was before.
But the costs of cutting inflation have been extraordinarily high. The economy has stagnated, with output no higher now than it was three years ago. Unemployment is poised to climb past 10 percent. Moreover, the end to the pain is not yet in sight. Even the optimists cannot yet find convincing signs that recovery has begun, while the pessimists think the economy may continue to slide for several months.
"It's hard to think of experiments that fail this badly and keep the very vocal support" that the Fed's 1979 shift in procedure has retained, economist George Perry of the Brookings Institution commented this week, calling the effects of monetary policy a "disaster."
There are others, however, who believe -- despite the recession -- that the post-1979 monetary techniques have been a success. The outgoing president of the Federal Reserve Bank of St. Louis said yesterday that "the new policies are beginning to show results." Lawrence Roos, who is a strict monetarist, warned against the "increasing pressures on the Federal Reserve to turn the policy clock back."
Perhaps it depends on the definition of success.
The original rationale for the Federal Reserve's shift was to improve its control over money supply growth. This, in turn, was supposed to influence inflation. It was argued that increases in the money supply feed through directly, predictably and fairly swiftly to increases in prices and wages across the economy. In order to control inflation, it therefore is necessary to control the rate of growth of money and thus put an effective limit on the amount of spending -- or gross national product. In the end, such a limit constrains prices rather than output and employment, monetarists argue.
Many observers believe that Paul Volcker, who was appointed chairman of the Federal Reserve Board in 1979, also wanted the operating changes for political reasons: to enable the Fed to pursue a tighter monetary policy than was politically possible when it bore more obvious responsibility for interest rates. The central bank, after all, had defined its monetary policy in terms of targets for money growth for several years. But before 1979, it used interest rates as a guide to hitting the targets, whereas now the Federal Open Market Committee, the policy-making arm of the Fed, sets its short-term policy targets in terms of bank reserves.
Most people believe that the operating changes have indeed succeeded both in keeping money closer to the targets and in achieving a tighter policy with higher interest rates than would have been possible otherwise. In Perry's words, the new procedures have been "an umbrella under which a very tight monetary policy could be carried out for a very long time."
That tight monetary policy, in turn, has been a major factor slowing inflation. Consumer prices have increased at an annual rate of close to 5 percent so far this year compared with more than 13 percent in 1979. There is "a good possibility that we could not have accomplished that disinflation under the old procedures," Elliott Platt of Donaldson, Lufkin and Jenrette said last week.
But the promise of the 1979 changes was not simply that tighter monetary policy eventually would lead to a slowdown in inflation via a sharp recession and high unemployment. It was that a more precise control of money growth would guide the economy surely and relatively effectively onto a lower inflation path, with lower interest rates and without too much loss of jobs and production.
Today's criticism of the policy comes really on two levels. On the first, it is argued that targeting a particular measure of money growth is a poor way of controlling total spending in the economy -- the ultimate goal. The link between any one measure of money and total gross national product is shaky and changeable. This year there has been less GNP for the amount of money in the economy than was expected. Other times, a given increase in the money supply has supported more spending growth than predicted.
Thus, controlling money growth, even if successful, may not lead to the desired level of GNP. "The operating procedures themselves have just been fraught with problems," one New York money expert said this week. Shifts in the composition of the various money measures, as financial innovations encouraged people to hold their spending money in different ways, turned the money numbers "into mush" just as policy focused more closely on them, he said. It is clearly silly for the Fed to tie policy to indicators that do not mean anything, if that is the case.
"One of the more foolish things" about monetarism, according to Nobel prize-winning economist James Tobin, is that "you should make policy blindfolded . . . that Paul Volcker shouldn't look out of the window" to judge how policy is affecting the economy.
In fact, Volcker does look out of his window. The Fed has allowed money growth to overshoot its targets for much of this year largely because the economy looks so weak, sources say. Volcker himself is not a strict monetarist and is known to believe that if the outlook remains dismal then the Federal Open Market Committee should not follow the monetary targets blindly.
But this leads to the second level of criticism: that policy is simply too tight now, and that the costs of such tight monetary control are far too great to accept.
On this view, tight monetary policy has worked to reduce inflation through the time-honored mechanism of depressing the economy, but it should be eased now. Instead, the Fed is being forced to hold interest rates up and stifle the economy by its commitment to monetary targets that themselves may be quite misleading. Although an enormous monetary expansion might be inflationary, there is no reason to rule out any easing at all just because of what is happening to money targets that are "purely arbitrary," Tobin argues.
Interest rates at today's level will continue to depress the economy, Perry said. "If that's what the advocates of these policies want, then they ought to say so. Then we could have a real discussion about where the economy is going and not where some uninteresting monetary aggregate is going."