Larry DeBoer
Professor of
Agricultural Economics
Purdue University

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The Fed and the Great Moderation

Everyone knows about the Great Depression, the disastrous downturn in the economy that lasted through the 1930s. Unemployment hit 25 percent and stayed above 10 percent for 10 years.

People over 40 remember the Great Inflation. From the mid-1960s to the early 1980s inflation went up and up, peaking at 13.5 percent in 1980. Prices rose three-fold.

Almost no one has heard of the Great Moderation. It's a name just coming into use to describe the years since the mid-1980s.

The highest unemployment rate from 1960 to 1986 was 9.7 percent. Since 1987, the highest unemployment rate has been 7.5 percent. The deepest recession between 1960 and 1986 reduced gross domestic product (GDP) by 1.9 percent, adjusted for inflation. Since 1987, the biggest real GDP decline has been 0.2 percent. The highest inflation rate in the earlier period was 13.5 percent. Since 1987, the highest inflation rate has been 5.4 percent.

The fluctuations in the economy have moderated since 1987. It's been Great Moderation.

What accounts for the Great Moderation? It might be simple good luck. Between 1960 and 1986 we had the Vietnam War and two oil price shocks, political events that had big effects on the economy. We haven't had anything quite so big in the past 20 years.

It might be new business technologies, such as improved inventory management. In former times, businesses only realized that their sales were down after their products began piling up on the shelves. They'd cancel orders from the factory, which would lay off employees. Now businesses know their sales and inventories day by day, and the adjustments to their factory orders are more gradual. Fluctuations in production and employment are smaller.

A third reason for the Great Moderation -- the most important, I think -- is that the Federal Reserve has figured out how to do monetary policy. The Fed has used policies that are more reliably "counter-cyclical" since the mid-1980s. Counter-cyclical policies try to offset the economy's main problem. If inflation is high, the Fed tries to reduce it by raising interest rates. If unemployment is high, the Fed tries to reduce it by cutting interest rates.

It's tempting to say, "What's the big deal?" Everyone knows what the Fed should do with interest rates during inflation and recession. The fact is, though, that from its founding in 1913 to about 1980, the Fed failed to do the right thing as often as not.

Consider the Great Depression. The roaring '20s were irrationally exuberant and the stock market crashed, but that was only enough to create a bad recession. The counter-cyclical policy in a recession is to reduce interest rates. Instead, the Fed increased interest rates to try to rescue the international gold standard. It failed to support the banking system with emergency loans -- the very thing the Fed had been created to do -- and one-third of all banks collapsed. These policy mistakes turned a severe recession into a Great Depression.

Consider the Great Inflation. Inflation rates began to creep upward starting in the mid-1960s. The rate was in double-digits by the mid-1970s. The counter-cyclical policy during inflation is the raise interest rates. But, in the second half of the 1970s, the Fed fell "behind the curve," reacting to increases in inflation too little, too late. Only at the end of the 1970s did interest rates rise substantially, and, by then, inflation was such a problem that it took a severe recession to get rid of it.

Since the mid-1980s, though, the Fed has mostly followed counter-cyclical policies. During the rise in inflation at the end of the 1980s, the Fed increased interest rates. During the recession of 1990-91, it decreased interest rates. When inflation threatened in the mid-90s and again at the end of the '90s, rates were increased. When the 2001 recession hit, rates were cut. Rates have increased recently, as inflation has again become a threat. Every move was counter-cyclical, and both inflation and recession have been milder as a result.

We blame the Great Depression and the Great Inflation on the Fed. We should probably credit the Fed with the Great Moderation.




Writer: Larry DeBoer
Editor: Cindie Gosnell