How the Fed lost its Compass: The Volker Rule
Summary: Forty years ago, the biggest problem our economy faced was high and
rising inflation. The Great Inflation demanded a clear focus on restoring the
credibility of the FOMC's commitment to price stability. Chair Paul Volcker
brought that focus to bear, and the "Volcker disinflation," with the continuing
stewardship of Alan Greenspan, led to the stabilization of inflation and
inflation expectations in the 1990s at around 2 percent. The monetary policies
of the Volcker era laid the foundation for the long period of economic stability
known as the Great Moderation.
…….We have also made important changes with regard to the price-stability side
of our mandate. Our longer-run goal continues to be an inflation rate of 2
percent. Our statement emphasizes that our actions to achieve both sides of our
dual mandate will be most effective if longer-term inflation expectations remain
well anchored at 2 percent. However, if inflation runs below 2 percent following
economic downturns but never moves above 2 percent even when the economy is
strong, then, over time, inflation will average less than 2 percent. Households
and businesses will come to expect this result, meaning that inflation
expectations would tend to move below our inflation goal and pull realized
inflation down. To prevent this outcome and the adverse dynamics that could
ensue, our new statement indicates that we will seek to achieve inflation that
averages 2 percent over time. Therefore, following periods when inflation has
been running below 2 percent, appropriate monetary policy will likely aim to
achieve inflation moderately above 2 percent for some time.
In seeking to achieve inflation that averages 2 percent over time, we are not
tying ourselves to a particular mathematical formula that defines the average.
Thus, our approach could be viewed as a flexible form of average inflation
targeting.26 Our decisions about appropriate monetary policy will continue to
reflect a broad array of considerations and will not be dictated by any formula.
Of course, if excessive inflationary pressures were to build or inflation
expectations were to ratchet above levels consistent with our goal, we would not
hesitate to act.
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It seems that the smooth market functioning does not include the US inflation
rate, which the Fed claimed initially as transitory and has had a difficult time
stamping out for fear of messing up some of the other policy objectives that it
now attributes to itself. Judging from what happened to the inflation rate, we
must conclude that either the Fed did not learn its lesson or perhaps during
COVID it had other overriding concerns that took priority over the inflation
rate. Either way the Fed failed in its implementation of monetary policy or
expanded its portfolio to pursue other objectives. No matter how we slice it,
the Fed appears to have lost its Volker Rule compass.
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Information contained in or attached to research report is for informational purposes only, does not constitute investment advice, and is not an advertisement or an offer of investment advisory services or a solicitation to become a client of LJE. The information is obtained from sources believed to be reliable, however, accuracy and completeness are not guaranteed by LJE.
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