Was Volcker disinflation actually Burns disinflation?

The hype of any policy usually has its precedents elsewhere.

This is a terrific paper by Thomas A. Lubik, Christian Matthes and Tim Sablik. They say that disinflation in 1980s was not due to Paul Volcker but started in previous tenure of Arthur Burns:

Economists often describe the Great Inflation of the 1970s as a failure of the monetary policy actions of the Federal Reserve under Chairman Arthur Burns. According to conventional wisdom, when Paul Volcker became chairman of the Fed in 1979, he implemented changes that ushered in a period of disinflation. This Economic Brief challenges this standard narrative in two ways. First, it argues that the “Volcker disinflation” had its roots in 1974. And second, Volcker’s actions were the culmination of a gradual shift in policy that began under Burns rather than an abrupt shift.

It was not as in Burns was sitting on high inflation:

Inflationary pressures mounted in 1974 as wage and price controls implemented by President Richard Nixon to contain inflation came to an end in April of that year. These pressures were further exacerbated by the first major oil embargo, which began in October 1973 and lasted until early 1974. Moreover, the country was in the midst of a recession that had begun in November 1973. The recession hit bottom in the winter of 1974–75 with the worst period of stagflation up to that point. Annual inflation rose to more than 10 percent, and unemployment increased to nearly 9 percent by the time the recession ended in March 1975.

The Fed responded to rising inflation by tightening monetary policy.6 Lubik and Matthes’ model shows that the Fed’s response was enough to put the economy on a stable path toward lower inflation, which lasted for roughly a year. But in part because of the Fed’s tightening, the economy dipped deeper into recession. The initial data from the first quarter of 1975 suggested a 10 percent loss (annualized) in GDP. At the same time, initial data suggested that inflationary pressures were contained. These early reports turned out to be false. The GDP numbers were later revised to a loss of about 5 percent, and inflation would rise again throughout the decade. But the initial data, coupled with political pressure to stimulate the economy, shook the Fed’s resolve as seen through the lens of Lubik and Matthes’ model.

In 1975, the Fed pulled back on its disinflationary stance, but not completely. Lubik and Matthes’ model shows that while the Fed’s responsiveness to inflation declined, it gradually moved toward a more predictable and disinflationary policy throughout the rest of the 1970s. Looking at the Fed’s long-run responses to inflation and changes in output — as modeled by Lubik and Matthes — the Volcker disinflation doesn’t appear to have been a dramatic shift in policy. Rather, it was the consistent follow-through of a gradual shift in the Fed’s inflation response that began in 1974. (See Figure 1.) 

So did Volcker not do anything? Nope. He continued the good work:

While Lubik and Matthes’ model indicates that Volcker’s policies were less of a break from Burns’ policies than the conventional wisdom suggests, Volcker still deserves credit for resisting political pressure to ease during the 1981–82 recession, which might have led to a continuation of the stop-go approach the Fed was seen as pursuing under Burns. What distinguishes Volcker from Burns in the minds of many is the fact that he followed through after initial disinflationary policy moves, a consistent approach that helped build and maintain the Fed’s credibility for keeping inflation in check. At the same time, Lubik and Matthes find that data measurement errors may have played a role in strengthening the Volcker Fed’s resolve. Real-time inflation data in the early 1980s indicated that inflation was much higher and more persistent than it actually was. This prompted the Volcker Fed to adopt stronger anti-inflationary policies than might have been warranted, which helped put inflation on a stable long-run path.

To illustrate this point, Lubik and Matthes estimate the results of their model using revised data. This exercise assumes (unrealistically) that the Fed had access to “perfect” information in real time. Under these assumptions, the model predicts a much more muted response to inflation, which may have delayed the Volcker disinflation.

These results suggest that there is some truth to both the “bad luck” and “bad data” explanations for the Great Inflation. Burns had the bad luck of working with inflation data that looked better than they were and economic data that looked worse than they were, prompting less aggressive anti-inflationary policies. Data errors for Volcker, in contrast, were biased toward higher inflation, supporting the more successful disinflationary policies for which he is known. At the same time, through the lens of Lubik and Matthes’ model, the Fed’s policies under Volcker appear to be more of a continuation of changes that began under Burns in 1974 rather than a dramatic shift. Therefore, Burns may deserve more credit for laying the groundwork for the Volcker disinflation.

Luck and data matter so much.

Who knows this narrative could fit India’s inflation story as well between 2011-14..

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out /  Change )

Google photo

You are commenting using your Google account. Log Out /  Change )

Twitter picture

You are commenting using your Twitter account. Log Out /  Change )

Facebook photo

You are commenting using your Facebook account. Log Out /  Change )

Connecting to %s

This site uses Akismet to reduce spam. Learn how your comment data is processed.

%d bloggers like this: