21 - The Volcker–Greenspan Regime

Summary

The lean-against-the-wind (LAW) character of policy whereby the FOMC raises (lowers) the funds rate in a persistent, measured way if the economy grows above (below) trend is the foundation of FOMC procedures. That fact, however, leaves two issues unsettled. First, how does the FOMC impose discipline on these changes to ensure that trend inflation remains unchanged? Second, how much knowledge does it possess about the real economy? Does it possess reliable knowledge of excess capacity or instead the lesser amount of knowledge of how the rate of resource utilization is changing?

The “expected-inflation/growth-gap” label used here to characterize monetary policy in the V–G era suggests the answers supplied in Sections I and II of this chapter. First, although the FOMC abandoned money targets in October 1982, its compass remained the desire to reanchor inflationary expectations unmoored by stop–go monetary policy. The FOMC monitored bond markets as the “canary in the coal mine” for expected inflation. It varied the frequency and magnitude of its routine LAW funds rate changes to the extent necessary to convince the market that those changes would cumulate to whatever extent required to maintain low, stable trend inflation. Second, the routine “housekeeping” funds rate changes that constitute LAW are a measured, persistent response to sustained changes in resource utilization (a growth gap). The Taylor Rule makes the more demanding (and unrealistic) assumption that the FOMC possesses reliable knowledge of excess capacity (an output or unemployment gap).