Monetary Policy When Potential Output is Uncertain: Understanding the Growth Gamble of the 1990s
56 Pages Posted: 17 Nov 2005
Date Written: November 4, 2005
The Fed kept interest rates low and essentially unchanged during the late 1990s despite a booming economy and record-low unemployment. These interest rates were accommodative by historical standards. Nonetheless, inflation remained low. How did the Fed succeed in sustaining rapid economic growth without fueling inflation and inflationary expectations? In retrospect, it is evident that the productive capacity of the economy increased. Yet as events unfolded, there was uncertainty about the expansion of the capacity of the economy and therefore about the sustainability of the Fed's policy.
This paper provides an explanation for the success of the Fed in accommodating noninflationary growth in the late 1990s. It shows that if the Fed is committed to reverse policy errors it makes because of unwarranted optimism, inflation can remain in check even if the Fed keeps interest rates low because of this optimism. In particular, a price level target - which is a simple way to model a commitment to offset errors - can serve to anchor inflation even if the public believes the Fed is overly optimistic about shifts in potential output. The paper shows that price level targeting is superior to inflation targeting in a wide range of situations. The paper also provides econometric evidence that, in contrast to earlier periods, the Fed has recently has put substantial weight on the price level in setting interest rates. Moreover, it shows that CPI announcement surprises lead to reversion in the price level. Finally, it provides textual evidence that Alan Greenspan puts relatively more weight on the price level than inflation.
Keywords: Monetary policy, Taylor rule, uncertain potential output
JEL Classification: C20, E42, E43
Suggested Citation: Suggested Citation