Monetary Policy and the Great Inflation in the United States: The Federal Reserve and the Failure of Macroeconomic Policy, 1965-79

Published by EH.NET (January 2000)

Thomas Mayer, Monetary Policy and the Great Inflation in the United States:

The

Federal Reserve and the Failure of Macroeconomic Policy,

1965-79. Cheltenham, UK and Northampton, MA: Edward Elgar Publishing,

1999. ix + 151 pp $70.00 (cloth), ISBN: 1-85898-953-1.

Reviewed for EH.NET by Stephen J. Perez, Department of Economics,

Washington State University.

Why did inflation rise to such frightening levels in the U.S. during the 1970s?

In his book, Monetary Policy and the Great Inflation, Thomas Mayer

analyzes and describes a vast amount of largely narrative evidence regarding

the formulation of monetary policy from 1965-1979. He uses a maintained

hypothesis that the Great Inflation was caused by monetary policy and takes as

his charge explaining the Federal Reserve’s willingness to accommodate the high

inflation

rates. According to Thomas Mayer,

“[t]here are several villains, and the biggest one turns out to be then

prevailing views of economists, and not malicious political interference with

the central bank, or cartel-imposed supply shocks. We have met the enemy and

he is (or rather was) us” (p. 117).

Professor Mayer uses sources ranging from the minutes of Federal Open Market

Committee (FOMC) meetings to economic textbooks of the time to interviews with

policy makers conducted in 1996 to try and sort through

several possible explanations for why the Federal Reserve pursued an

expansionary policy during the Great Inflation. The possible explanations

include: bad forecasting by the Federal Reserve, poor control over the money

supply, cognitive errors, political pressure, wage, price, dividend,

and interest rate controls (Nixon’s incomes policies), and poor economic

advice.

As a graduate student at UC Davis, I had the distinct pleasure of taking two

classes in monetary theory and policy from Professor Mayer. I

am heartened to know that he continues to attack problems with the methodical

and intellectual style with which he taught. Professor Mayer systematically

evaluates the possibility that each of the above reasons could have lead to the

Federal Reserve’s role in the Great Inflation. In each case, he makes great

use of the minutes and interviews he conducted detailing evidence both for and

against each explanation.

Is it possible that the Federal Reserve was simply misled by poor forecasts of

future economic performance? It is true that the Federal Reserve staff

systematically underestimated future inflation and overestimated potential

output. However, Professor Mayer attributes a maximum of 3 to 10% of the

inflation to these misestimates. Did poor control

over the money supply lead to excessive monetary growth? Although there may

have been an accommodative policy bias, poor control of the money supply should

have led to mistakes towards accommodative and restrictive policy.

Professor Mayer attributes a small possible role to cognitive errors such as

vagueness of policy, procrastination, a short run bias, the role of

expectations, etc. But, the most interesting analysis lies in chapters

regarding political

pressure, price controls, and the influence of economists.

Professor Mayer looks very carefully for evidence that the Federal Reserve

experienced pressure from the administration or Congress to follow an

accommodative policy. Other than a few instances, the following excerpt

summarizes the role of political influence: “The political pressures the Fed

actually experienced appear to have played only a relatively minor role in the

Great Inflation, so that direct cause of the Great Inflation was primarily the

Fed’s own inflationary proclivity. But if the Fed had been much less inclined

to tolerate inflation, political pressures might well have forced it to do so”

(p. 81).

The possibility of political pressure also plays a role in the discussion of

the role of how the Nixon wage and price controls affected

the formulation of monetary policy. Professor Mayer finds evidence that the

FOMC may have been influenced by the specter of interest rate controls if it

became too contractionary. The wage and price controls may have also lead the

FOMC to become more expansionary with the belief that the incomes policies

would hold down inflationary expectations.

Professor Mayer finds the main cause of the expansionary monetary policy to be

the correlation of the FOMC’s attitudes towards inflation with those of

academic

economists. In particular, both the FOMC and academic economists felt that

monetary policy should play a reduced role in fighting cost-push inflation,

that the cost of fighting cost-push inflation was very high, and that the NAIRU

was relatively low and

both failed to fully realize the lack of a tradeoff between inflation and

unemployment in the long run. In summary, Professor Mayer states: “My own

ranking [of causes of the Great Inflation] is to put the intellectual

atmosphere in first place, and cognitive errors, political pressures and the

wish to avoid interest-rate fluctuations, in second, third and fourth place

respectively,  Well behind these come inadequate operating procedures, and

even further behind, the pressures exerted from the imposition

of wage and price controls” (p. 120).

Monetary Policy and the Great Inflation in the United States is a very

enlightening description of how monetary policy lead to the Great Inflation.

Professor Mayer displays his typically thorough analytical skills

and clear writing style while describing a wealth of source level evidence

regarding the thought process of monetary policy makers.

Stephen J. Perez is Assistant Professor of Economics at Washington State

University. He is author of numerous works including “Data Mining

Reconsidered: Encompassing and the General-to-Specific Approach to

Specification Search.” Econometrics Journal, Vol. 2, (with Kevin D.

Hoover); “Causal Ordering and the ‘Bank Lending Channel’.” Journal of

Applied Econometrics, (Nov.-

Dec. 1998); “Testing for Credit Rationing: An Application of Disequilibrium

Econometrics.” Journal of Macroeconomics,

(Fall 1998); “Post Hoc Ergo Propter Hoc Once More: An Evaluation of ‘Does

Monetary Policy Matter?’ in the Spirit of James Tobin.” Journal of Monetary

Economics, (August 1994) (with Kevin D. Hoover).