In order to understand how we got to where we go to the 70s we need to understand the mentality of policy ideas underpinned the
period the rule turned out in the 1960s because of the desire that was there in policy circles and in academia to use the
tools of macroeconomics that had been developed the previous couple of decades to use economic policy to deliver in great
society. Eliminate the business cycle. Fine tune the economy to have maximum employment all the time while respecting price
stability. And the goals were noble. Managing all of these things would have been wonderful.
In theory the difficulty is that in practice you can never deliver all of those all of those goals. Policy makers in order
to stabilize the economy need to understand what normal is. And they were they were trying to stabilize the economy at the level
of unemployment that was too optimistic at the level of output that was too optimistic effectively allowing a drift of
inflation to to develop over time.
It's quite ironic that that I do blame and many others blame are there specifically as the chair of the Fed at the time. Look for
that in 1970. It's quite ironic cause our forbearance was was the person who literally had written the book on business
cycles. You will recall his his great work with Wesley Meacher on the business cycle and in his writings. In the 1950s and
1960s. He he he showed that he was very well aware of the limits of
stabilization policy of the risks of a monetary policy not focused on price stability. And yet under his chairmanship. We
ended up with with credit but with pretty bad outcomes. In my view
at the end of the day after Barron's much like most other policymakers felt that
it was the responsibility of the Federal Reserve to deliver maximum employment. That after all the was in the law and did
not quite internalized correctly. And I think in retrospect we can be clear that he did not internalize correctly correctly.
How much damage one would do in the long term to the economy by losing by losing track of price stability and letting inflation
get out of control.
I have to start by by mentioning one thing that we didn't really put in that paper that is actually very very important.
If you want to hear that story. You need to go and find Joe Coins collection from 1979 that the
Federal Reserve press has published in its in its oral history. Just how crazy was it that it was shock therapy. It was shock
therapy. The Paul was called the meeting on Saturday. Saturday ended with
the same Sabbath day when the pope was visiting Washington D.C.. We didn't put that in the paper but it's actually consequential
because since the pope was visiting for Washington D.C. and the Pope had a meeting at the mall right outside the fact is if you
know if the Fed is on Constitution Avenue. Right right. Overlooking the Mall. So this is consequential of course. The
joke coin who was of course the chief of communication at the Fed at the time had a very hard time finding reporters to come
and report on the outcome of the meeting. And what what Paul Volcker wanted to do was was used shock therapy to explain to
everybody that that what they had observed every bit of the miscommunication that had happened in September was a mistake.
It did not reflect the Fed's plan to restore price stability. And he wanted to highlight that things would drastically change
in how the Federal Reserve operated to avoid repeating the operating procedures I should say avoid continuing with the
operating procedures. That CAP failed to restore price stability. So they changed operating procedure was effectively
saying look we have been using the federal funds rate as the primary instrument for gradual adjustments in policy and in
doing the gradual adjustments in policy. We have demonstrated in the that in the late 70s that we have
not managed to calibrate the level of the federal funds rate to be sufficiently restrictive to reduce inflation and put and put
the country on a path to price stability. She had to change operating procedures because the reliance on the federal funds
rate cuts failed. Why had it failed. Because the inflation process and the inflation expectations
process were no longer unclear. And the Federal Reserve could not tell if it was raising the real interest rate which is what
it needed to do in order to to to this inflate by changing the operating procedures.
Paul Volcker effectively adopted a framework that had some disadvantages. We can discuss those those later on. But it had
the advantage that if force was the message of the policy on a reduction in the money supply which like it or not is gonna
tighten monetary conditions and eventually deliver price stability even without knowing what the appropriate level of the
federal funds rate that would be needed to respond to what shock therapy to get us back to a path to price stability. Even though
at the time they didn't know whether it would work very well they didn't know whether it would be credible. They didn't know
whether they would stick with it with over or over several months. They were very very important to have the shock therapy
and have the message in order to have a chance to change expectations and re-establish the Fed's credibility. When I have
a letter Paul Volcker wrote here in 2004 when Bob Russian I wear a core organising the conference he and others simply said on
the on the 10th anniversary. And he highlighted the there is reason that that he adopted the
the monetary targeting procedure. And let me let me quote this. He says The change to stricter monetary policy targeting seemed
to me to be one and the same to build on the public perception of quote too much money. Quote inflation end quote and to
discipline ourselves how to retreat without embarrassment. So he did fine. He did fine. Those additional elements helpful in
adopting the monetary procedure at the time. And another one I will give you this one more sentence from this quote. He says
And I can't remember how many times I struck out the word gradually from staff drafts.
I will first start with with the Senate with a couple of sentences from another letter that Paul Volcker wrote to Bill
Paul. We failed to get him to come to our conference and we failed to
have him contribute something to the volume back in 2004. But we were successful in having him write two letters and then one of
them he gave what what I believe is some of the most important lessons from that experience. And he assertion that in that
letter this is the letter written on May 26 2000 for by Paul Order of 2 to Bill Paul then president of the Senate. We
said and he says I have one less one intelligible in my brain. Don't let inflation get ingrained.
Once that happens there's too much agony in stopping the momentum.
That's the key lesson. And
I want to I want to stress this is a lesson that in my experience observing the Federal Reserve both during the time I
was there. And since then you know I've been I've been under the Fed for 15
years now. If I if I have make my timing right is that this is this is a lesson that I believe the
Federal Reserve has espoused. And and I hope that that it will be committed to going forward. What do you mean by that.
Consider a change in the monetary policy strategy in 2000. Well for the first time in its history in 2012 the Federal Reserve
says yes we have a clear definition of price stability 2 percent. You know you may you may you may discuss you know
should it be one two or three. Doesn't matter. What's important is saying we have a clear definition of price stability and our
policy will be formulated so that in the long term we deliver on that objective we will deliver price stability. We are in charge
of price stability and we will deliver on price stability. This is one thing. The second thing which again relates to to the
core. I just I just I just read you from from Paul Volcker is a pay extreme attention to maintain inflation expectations. Well
I'm caught in line with definition of price stability. If your definition of price stability is two percent inflation over time
then you want medium to long term inflation expectations. But financial markets by and by households to be focused on two
percent inflation and they see that element being highlighted both in their 2012 policy strategy statement by the Federal
Reserve put out. And also this is the one element that that actually support the revision
of the policy strategy that was implemented in 2020. The FOMC decided to double down on how important it is to keep inflation
expectations are well unquote then maybe that's an important lesson because that means that it gives
the Federal Reserve guidance about how aggressive policy needs to be on the circumstances where events are not coming the way
you expected them to. Mistakes happen. Policy has to be forward looking at some point forecast mistakes are quite common. And
what we observe from time to time like we have been observing over the past couple of years is pretty pretty big forecast
errors. Now as it happens the forecast that we have observed over the past year for example have ended up delivering
inflation much higher than was anticipated and have actually started to some core inflation expectations. If you were to take
these fundamental lessons from Paul Volunteers experience which I think the Fed has pretty much taken on board since then we
need a forceful response to the threat of this oncoming inflation expectations. And if that means not being as
gradualist as some policymakers would would want us to be and predictable as some policymakers would would want us to be so be
it. Let me remind you Paul Volcker your recollection from 1979. I will rate this sentence again.
I can't remember how many times I struck out. They were gradually from staff drafts. You need to maintain inflation
expectations. You need to make sure inflation does not get out of control. And you know if you need shock therapy to do this so
be it. Go for it.