Suman Bery: Understanding the great moderation

Are central banks really responsible for low global inflation.

In his speech before a gathering of international economists in Mumbai recently (organised by the Institute for International Finance of Washington D.C. and the State Bank of India), RBI Deputy Governor Rakesh Mohan drew attention to the so-called "Great Moderation". He was referring to the sustained decline in inflation and inflation volatility in both OECD and developing countries that has characterised the past 15 years, in comparison with the period immediately preceding it.

As was pointed out in the Mohan speech, if one compares the period since the Asian crisis (1998-2007) with the 30 preceding years (1970-97) average inflation as measured by the consumer price index (CPI) has averaged 1.9% down from 5.8% in the earlier period. Not only has average inflation been lower, its variability (volatility) has also been lower. A similar pattern also exists for the developing world. As we all know, the era of this "great moderation" has been associated with an extraordinary spurt of growth in the global economy, led for much of the period by the US.

How did this shift come about? The answer, according to Prof. Marvin Goodfriend of Carnegie-Mellon University, can be summed up in two words: Paul Volcker.

Prof. Goodfriend was delivering the Foundation Day lecture at the Reserve Bank in Mumbai, commemorating the Silver Jubilee of the RBI Archives. He is a well-known analytic historian of the US Federal Reserve system and has had a ringside view of the decisions taken by the Fed's Open Market Committee (FOMC) in the 1990s when he served as Senior Vice-President at the Federal Reserve Bank of Richmond, one of the constituent banks that votes at the FOMC.

Goodfriend's talk was based on more than his personal observations, however. It drew upon an extensive review of the minutes of the FOMC, and on transcriptions of the discussion at the FOMC which are released after a five-year delay. His speech was impressive and powerful testimony to the value and importance of having complete and accessible records of official decision-making. Through its official history the Reserve Bank (as also the State Bank) has set an important example, but I am not aware that much academic scholarship has followed upon their lead.

In his prepared remarks, but even more in his responses to questions from the floor, Prof. Goodfriend made it abundantly clear that he believed that "mistakes and subsequent successes" of the last quarter century of monetary policy in the US can take significant credit for the great moderation noted above, and the benign world environment that has thereafter ensued. I recognise that in the minds of many (not least my fellow columnist Surjit Bhalla) these claims would be dismissed as central bank egocentricity, with monetary policy playing at best a minor role.

His analysis starts with the drift away from the gold standard that began early in the 20th century, reflected in the establishment of the Federal Reserve in 1913. He notes that "the political drive toward discretionary monetary policy predated an operational understanding of its pitfalls, with disastrous consequences". The Great Depression of the 1930s and the inflation of the 1960s and 1970s were the result.

A series of advances in monetary policy, specifically following the arrival of Volcker as Fed chairman in 1979, finally tamed the risks associated with fiat money, and ushered in the great moderation. The policy package resulting from this process is the familiar combination of implicit or explicit inflation targeting coupled with a floating exchange rate. The more interesting parts of the story are regarding implementation: how credibility needs to be won; the role of transparency and communication in the links between short-run nominal interest rates to long-term real interest rates.

Goodfriend does not reject the idea of counter-cyclical monetary policy. Rather, he sees the purpose of credibile strategic guidance as being precisely to build up an intangible asset in normal times that can be used aggressively in downturns without creating an inflation scare. As Martin Wolf has recently observed, this is exactly the situation facing the major central banks today, and is the source of the so-called "Greenspan put" that may have encouraged excessive risk taking.

Goodfriend does caution that exchange rate policy represents the Achilles' heel of central bank independence and effective monetary policy even today in OECD countries. While monetary theory and practice clearly indicate that exchange rate policy and monetary policy are, as it were, joined at the hip, the institutional responsibility for the former still lies in most OECD countries with the Treasury, which is more subject to political pressure than an independent central bank. As he puts it, "the only way the Treasury can influence the exchange rate is to persuade or pressurise the central bank to pursue inflationary policy."

Volcker comes across as Goodfriend's hero for at least two reasons. First, in 1981 he had the conceptual foresight and moral courage to understand that there were immense long-term gains to be reaped by lowering inflation expectations to low single digits and second because he was repeatedly prepared to take pre-emptive action to reinforce and publicise the Fed's commitment to its inflation goals.

Based on his reading of the Volcker experience, Goodfriend stresses that all it takes to reset inflation expectations is a determined, independent central bank willing to court short-term unpopularity for long-term stability, credibility and growth. As he stresses in his lecture, "inflation can be brought down with monetary policy alone, without the support of wage, price or credit controls, and without supportive fiscal policy."

At the lecture Goodfriend was asked whether globalisation and the rise of India and China were not more responsible for the great disinflation of the 1980s and 1990s. His response was immediate: Volcker, by reviving an exhausted and dispirited American capitalism made China and India possible, not the other way round. By the same token, Greenspan's job was much easier, since it involved consolidating credibility that Volcker had already established.

Space does not allow me to dwell on the implications of the speech for India today, nor to address many of the criticisms of U.S. monetary policy in the Greenspan years that are currently rife. I will make those the subject of a future article.

The author is Director-General, National Council of Applied Economic Research. The views expressed are personal