Ben S Bernanke: The great moderation
Remarks by Mr Ben S Bernanke, Member of the Board of Governors of the US Federal Reserve
System, at the meetings of the Eastern Economic Association, Washington DC, 20 February 2004.
The references for the speech can be found on the Board of Governors of the Federal Reserve System's website.
* * *
One of the most striking features of the economic landscape over the past twenty years or so has
been a substantial decline in macroeconomic volatility. In a recent article, Olivier Blanchard and John
Simon (2001) documented that the variability of quarterly growth in real output (as measured by its
standard deviation) has declined by half since the mid-1980s, while the variability of quarterly inflation
has declined by about two thirds.1 Several writers on the topic have dubbed this remarkable decline in
the variability of both output and inflation "the Great Moderation". Similar declines in the volatility of
output and inflation occurred at about the same time in other major industrial countries, with the recent
exception of Japan, a country that has faced a distinctive set of economic problems in the past
decade.
Reduced macroeconomic volatility has numerous benefits. Lower volatility of inflation improves market
functioning, makes economic planning easier, and reduces the resources devoted to hedging inflation
risks. Lower volatility of output tends to imply more stable employment and a reduction in the extent of
economic uncertainty confronting households and firms. The reduction in the volatility of output is also
closely associated with the fact that recessions have become less frequent and less severe.2
Why has macroeconomic volatility declined? Three types of explanations have been suggested for this
dramatic change; for brevity, I will refer to these classes of explanations as structural change,
improved macroeconomic policies, and good luck. Explanations focusing on structural change suggest
that changes in economic institutions, technology, business practices, or other structural features of
the economy have improved the ability of the economy to absorb shocks. Some economists have
argued, for example, that improved management of business inventories, made possible by advances
in computation and communication, has reduced the amplitude of fluctuations in inventory stocks,
which in earlier decades played an important role in cyclical fluctuations.3 The increased depth and
sophistication of financial markets, deregulation in many industries, the shift away from manufacturing
toward services, and increased openness to trade and international capital flows are other examples
of structural changes that may have increased macroeconomic flexibility and stability.
The second class of explanations focuses on the arguably improved performance of macroeconomic
policies, particularly monetary policy. The historical pattern of changes in the volatilities of output
growth and inflation gives some credence to the idea that better monetary policy may have been a
major contributor to increased economic stability. As Blanchard and Simon (2001) show, output
volatility and inflation volatility have had a strong tendency to move together, both in the United States
and other industrial countries. In particular, output volatility in the United States, at a high level in the
immediate postwar era, declined significantly between 1955 and 1970, a period in which inflation
volatility was low. Both output volatility and inflation volatility rose significantly in the 1970s and early
1980s and, as I have noted, both fell sharply after about 1984. Economists generally agree that the
1970s, the period of highest volatility in both output and inflation, was also a period in which monetary
policy performed quite poorly, relative to both earlier and later periods (Romer and Romer, 2002).4
Few disagree that monetary policy has played a large part in stabilizing inflation, and so the fact that
output volatility has declined in parallel with inflation volatility, both in the United States and abroad,
suggests that monetary policy may have helped moderate the variability of output as well.
The third class of explanations suggests that the Great Moderation did not result primarily from
changes in the structure of the economy or improvements in policymaking but occurred because the
shocks hitting the economy became smaller and more infrequent. In other words, the reduction in
good
macroeconomic volatility we have lately enjoyed is largely the result of luck, not an intrinsically
more stable economy or better policies. Several prominent studies using distinct empirical approaches
have provided support for the good-luck hypothesis (Ahmed, Levin, and Wilson, 2002; Stock and
Watson, 2003).
Explanations of complicated phenomena are rarely clear cut and simple, and each of the three classes
of explanations I have described probably contains elements of truth. Nevertheless, sorting out the
relative importance of these explanations is of more than purely historical interest. Notably, if the Great
Moderation was largely the result of good luck rather than a more stable economy or better policies,
then we have no particular reason to expect the relatively benign economic environment of the past
twenty years to continue. Indeed, if the good-luck hypothesis is true, it is entirely possible that the
variability of output growth and inflation in the United States may, at some point, return to the levels of
the 1970s. If instead the Great Moderation was the result of structural change or improved
policymaking, then the increase in stability should be more likely to persist, assuming of course that
policymakers do not forget the lessons of history.
My view is that improvements in monetary policy, though certainly not the only factor, have probably
been an important source of the Great Moderation. In particular, I am not convinced that the decline in
primarily
macroeconomic volatility of the past two decades was the result of good luck, as some have
argued, though I am sure good luck had its part to play as well. In the remainder of my remarks, I will
provide some support for the "improved-monetary-policy" explanation for the Great Moderation. I will
not spend much time on the other two classes of explanations, not because they are uninteresting or
unimportant, but because my time is limited and the structural change and good-luck hypotheses have
been extensively discussed elsewhere.5 Before proceeding, I should note that my views are not
necessarily those of my colleagues on the Board of Governors or the Federal Open Market
Committee.
The Taylor curve and the variability tradeoff
Let us begin by asking what economic theory has to say about the relationship of output volatility and
inflation volatility. To keep matters simple, I will make the strong (but only temporary!) assumption that
monetary policymakers have an accurate understanding of the economy and that they choose policies
to promote the best economic performance possible, given their economic objectives. I also assume
for the moment that the structure of the economy and the distribution of economic shocks are stable
and unchanging. Under these baseline assumptions, macroeconomists have obtained an interesting
and important result. Specifically, standard economic models imply that, in the long run, monetary
only
policymakers can reduce the volatility of inflation by allowing greater volatility in output growth,
and vice versa. In other words, if monetary policies are chosen optimally and the economic structure is
held constant, there exists a long-run tradeoff between volatility in output and volatility in inflation.
The ultimate source of this long-run tradeoff is the existence of shocks to aggregate supply. Consider
the canonical example of an aggregate supply shock, a sharp rise in oil prices caused by disruptions
to foreign sources of supply. According to conventional analysis, an increase in the price of oil raises
the overall price level (a temporary burst in inflation) while depressing output and employment.
Monetary policymakers are therefore faced with a difficult choice. If they choose to tighten policy (raise
the short-term interest rate) in order to offset the effects of the oil price shock on the general price
level, they may well succeed - but only at the cost of making the decline in output more severe.
Likewise, if monetary policymakers choose to ease in order to mitigate the effects of the oil price shock
on output, their action will exacerbate the inflationary impact. Hence, in the standard framework, the
periodic occurrence of shocks to aggregate supply (such as oil price shocks) forces policymakers to
choose between stabilizing output and stabilizing inflation.6 Note that shocks to aggregate demand do
not create the same tradeoff, as offsetting an aggregate demand shock stabilizes both output and
inflation.
This apparent tradeoff between output variability and inflation variability faced by policymakers gives
rise to what has been dubbed the Taylor curve, reflecting early work by the Stanford economist and
current Undersecretary of the Treasury John B. Taylor.7 (Taylor also originated the eponymous Taylor
rule, to which I will refer later.) Graphically, the Taylor curve depicts the menu of possible
combinations of output volatility and inflation volatility from which monetary policymakers can choose
in the long run. Figure 1 shows two examples of Taylor curves, marked TC1 and TC2. In Figure 1,
volatility in output is measured on the vertical axis and volatility in inflation is measured on the
horizontal axis. As shown in the figure, Taylor curves slope downward, reflecting the theoretical
conclusion that an optimizing policymaker can choose less of one type of volatility in the long run only
by accepting more of the other.8 A direct implication of the Taylor curve framework is that a change in
the preferences or objectives of the central bank alone - a decision to be tougher on inflation, for
example - cannot explain the Great Moderation. Indeed, in this framework, a conscious attempt by
policymakers to try to moderate the variability of inflation should lead to higher, not lower, variability of
output.
How, then, can the Great Moderation be explained? Figure 1 suggests two possibilities. First, suppose
it were the case, contrary to what we assumed in deriving the Taylor curve, that monetary policies
during the period of high macroeconomic volatility were not optimal, perhaps because policymakers
did not have an accurate understanding of the structure of the economy or of the impact of their policy
actions. If monetary policies during the late 1960s and the 1970s were sufficiently far from optimal, the
result could be a combination of output volatility and inflation volatility lying well above the efficient
frontier defined by the Taylor curve. Graphically, suppose that the true Taylor curve is the solid curve
shown in Figure 1, labeled TC2. Then, in principle, sufficiently well executed policies could achieve a
combination of output volatility and inflation volatility such as that represented by point B, which lies on
that curve. However, less effective policies could lead to the economic outcome represented by
A
point in Figure 1, at which both output volatility and inflation volatility are higher than at point B. We
can see now how improvements in monetary policy might account for the Great Moderation, even in
the absence of any change in the structure of the economy or in the underlying shocks. Improvements
in the policy framework, in policy implementation, or in the policymakers' understanding of the
economy could allow the economy to move from the inefficient point A to the efficient point B, where
the volatility of both inflation and output are more moderate.
Figure 1 can also be used to depict a second possible explanation for the Great Moderation, which is
that, rather than monetary policy having improved, the underlying economic environment may have
become more stable. Changes in the structure of the economy that increased its resilience to shocks
or reductions in the variance of the shocks themselves would improve the volatility tradeoff faced by
policymakers. In Figure 1, we can imagine now that the true Taylor curve in the 1970s is given by the
dashed curve, TC1, and the actual economic outcome chosen by policymakers is point A, which lies
on TC1. Improved economic stability in the 1980s and 1990s, whether arising from structural change
or good luck, can be represented by a shift of the Taylor curve from TC1 to TC2, and the new
TC2
economic outcome as determined by policy is point B. Relative to TC1, the Taylor curve
represents economic outcomes with lower volatility in output for any given volatility of inflation, and
vice versa. According to the "shifting Taylor curve" explanation, the Great Moderation resulted not from
improved practice of monetary policy (which has always been as effective as possible, given the
environment) but rather by favorable structural change or reduced variability of economic shocks. Of
and
course, more complicated scenarios in which policy becomes more effective the underlying
economic environment becomes more stable are possible and indeed likely.
With this bit of theory as background, I will focus on two key points. First, without claiming that
monetary policy during the 1950s or in the period since 1984 has been ideal by any means, I will try to
support my view that the policies of the late 1960s and 1970s were particularly inefficient, for reasons
that I think we now understand. Thus, as in the first scenario just discussed (represented in Figure 1
A
as a movement from point to point B), improvements in the execution of monetary policy can
plausibly account for a significant part of the Great Moderation. Second, more subtly, I will argue that
some of the benefits of improved monetary policy may easily be confused with changes in the
underlying environment (that is, improvements in policy may be incorrectly identified as shifts in the
Taylor curve), increasing the risk that standard statistical methods of analyzing this question could
understate the contribution of monetary policy to the Great Moderation.
Reaching the Taylor curve: improvements in the effectiveness of monetary policy
Monetary policymakers face difficult challenges in their efforts to stabilize the economy. We are
uncertain about many aspects of the workings of the economy, including the channels by which the
effects of monetary policy are transmitted. We are even uncertain about the current economic situation
as economic data are received with a lag, are typically subject to multiple revisions, and in any case
can only roughly and partially depict the underlying economic reality. Thus, in practice, monetary
policy will never achieve as much reduction in macroeconomic volatility as would be possible if our
understanding were more complete.
Nevertheless, a number of economists have argued that monetary policy during the late 1960s and
the 1970s was unusually prone to creating volatility, relative to both earlier and later periods (DeLong,
1997; Mayer, 1998; Romer and Romer, 2002). Economic historians have suggested that the relative
inefficiency of policy during this period arose because monetary policymakers labored under some
important misconceptions about policy and the economy. First, during this period, central bankers
seemed to have been excessively optimistic about the ability of activist monetary policies to offset
shocks to output and to deliver permanently low levels of unemployment. Second, monetary
policymakers appeared to underestimate their own contributions to the inflationary problems of the
time, believing instead that inflation was in large part the result of nonmonetary forces. One might say
that, in terms of their ability to deliver good macroeconomic outcomes, policymakers suffered from
excessive "output optimism" and "inflation pessimism."
The output optimism of the late 1960s and the 1970s had several aspects. First, at least during the
early part of that period, many economists and policymakers held the view that policy could exploit a
permanent tradeoff between inflation and unemployment, as described by a simple Phillips curve
relationship. The idea of a permanent tradeoff opened up the beguiling possibility that, in return for
accepting just a bit more inflation, policymakers could deliver a permanently low rate of
unemployment. This view is now discredited, of course, on both theoretical and empirical grounds.9
Second, estimates of the rate of unemployment that could be sustained without igniting inflation were
typically unrealistically low, with a long-term unemployment rate of 4 percent or less often being
characterized as a modest and easily attainable objective.10 Third, economists of the time may have
been unduly optimistic about the ability of fiscal and monetary policymakers to eliminate short-term
fluctuations in output and employment, that is, to "fine-tune" the economy.
What I have called inflation pessimism was the increasing conviction of policymakers in the 1960s and
1970s, as inflation rose and remained stubbornly high, that monetary policy was an ineffective tool for
controlling inflation. As emphasized in recent work on the United States and the United Kingdom by
Edward Nelson (2004), during this period policymakers became more and more inclined to blame
inflation on so-called cost-push shocks rather than on monetary forces. Cost-push shocks, in the
paradigm of the time, included diverse factors such as union wage pressures, price increases by
oligopolistic firms, and increases in the prices of commodities such as oil and beef brought about by
adverse changes in supply conditions. For the purpose of understanding the upward trend in inflation,
however, the most salient attribute of cost-push shocks was that they were putatively out of the control
of the monetary policymakers.
The combination of output optimism and inflation pessimism during the latter part of the 1960s and the
1970s was a recipe for high volatility in output and inflation - that is, a set of outcomes well away from
the efficient frontier represented by the economy's Taylor curve. Notably, the belief in a long-run
tradeoff between output and inflation, together with an unrealistically low assessment of the
sustainable rate of unemployment, resulted in high inflation but did not deliver the expected payoff in
terms of higher output and employment. Moreover, the Fed's periodic attempts to rein in surging
inflation led to a pattern of "go-stop" policies, in which swings in policy from ease to tightness
contributed to a highly volatile real economy as well as a highly variable inflation rate. Wage-price
controls, invoked in the belief that monetary policy was ineffective against cost-push forces, also
ultimately proved destabilizing.
Monetary policymakers bemoaned the high rate of inflation in the 1970s but did not fully appreciate
their own role in its creation. Ironically, their errors in estimating the natural rate and in ascribing
inflation to nonmonetary forces were mutually reinforcing. On the one hand, because unemployment
remained well above their over-optimistic estimates of the sustainable rate, they were inclined to
attribute inflation to outside forces (such as the actions of firms and unions) rather than to an
overheated economy (Romer and Romer, 2002; Nelson, 2004). On the other hand, the view of
policymakers that exogenous forces largely drove inflation made it more difficult for them to recognize
that their estimate of the sustainable rate of unemployment was too low. Several years passed before
policymakers were finally persuaded by the evidence that sustained anti-inflationary monetary policies
would actually work (Primiceri, 2003). As you know, these policies were implemented successfully
after 1979, beginning under Fed Chairman Volcker.
Better known than even the Taylor curve is John Taylor's famous Taylor rule, a simple equation that
has proved remarkably useful as a rule-of-thumb description of monetary policy (Taylor, 1993). In its
basic form, the Taylor rule relates the Federal Reserve's policy instrument, the overnight federal funds
interest rate, to the deviations of inflation and output from the central bank's desired levels for those
variables. Estimates of the Taylor rule for the late 1960s and the 1970s reflect the output optimism and
inflation pessimism of the period, in that researchers tend to find a weaker response of the policy rate
to inflation and (in some studies) a relatively stronger response to the output gap than in more recent
periods.11 As I will shortly discuss further, an insufficiently strong response to inflation let inflation and
inflation expectations get out of control and thus added volatility to the economy. At the same time,
strong responses to what we understand in retrospect to have been over-optimistic estimates of the
output gap created additional instability. As output optimism and inflation pessimism both waned under
the force of the data, policy responses became more appropriate and the economy more stable. In this
sense, improvements in policymakers' understanding of the economy and the role of monetary policy
A
allowed the economy to move closer to the Taylor curve (or, in terms of Figure 1, to move from point
to point B).
Improved monetary policy or a shifting Taylor curve?
Improvements in monetary policy that moved the economy closer to the efficient frontier described by
the Taylor curve can account for part of the Great Moderation. However, several empirical studies
have questioned the quantitative importance of this effect and emphasized instead shifts in the Taylor
curve, brought about by structural change or good luck. For example, in a paper presented at the
Federal Reserve Bank of Kansas City's annual Jackson Hole conference, James Stock and Mark
Watson (2003) use several alternative macroeconomic models to simulate how the economy would
have performed after 1984 if monetary policy had followed its pre-1979 pattern. Although inflation
performance after 1984 would clearly have been worse if pre-1979 monetary policies had been used,
Stock and Watson find that output volatility would have been little different. They conclude that
improved monetary policy does not account for much of the reduction in output volatility since the
mid-1980s. Instead, noting that the variance of the economic shocks implied by their models for the
1970s was much higher than the variance of shocks in the more recent period, they embrace the
good-luck explanation of the Great Moderation. Interesting research by Timothy Cogley and Thomas
Sargent (2002) and by Shaghil Ahmed, Andrew Levin, and Beth Anne Wilson (2002) likewise find a
substantial reduction in the size and frequency of shocks in the more recent period, supporting the
good-luck hypothesis.
Both the structural change and good-luck explanations of the Great Moderation are intriguing and (to
reiterate) both are no doubt part of the story. However, an unsatisfying aspect of both explanations is
the difficulty of identifying changes in the economic environment large enough and persistent enough
to explain the Great Moderation, both in the United States and abroad. In particular, it is not obvious
that economic shocks have become significantly smaller or more infrequent, as required by the
goodluck hypothesis. Tensions in the Middle East, often blamed for the oil price shocks of the 1970s, have
hardly declined in recent years, and important developments in technology and productivity have
continued to buffet the economy (albeit in a more positive direction than in the 1970s). Nor has the
international economic environment become obviously more placid, as a series of financial crises
struck various regions of the world during the 1990s and the powerful forces of globalization have
proceeded apace. In contrast, following the adverse experience of the 1970s, changes in the practice
of monetary policy occurred around the world in similar ways and during approximately the same
period.
Certainly, stability-enhancing changes in the economic environment have occurred in the past two
decades. However, an intriguing possibility is that some of these changes, rather than being truly
exogenous, may have been induced by improved monetary policies. That is, better monetary policies
may have resulted in what appear to be (but only appear to be) favorable shifts in the economy's
Taylor curve. Here are some examples of what I have in mind.
First, monetary policies that brought down and stabilized inflation may have led to stabilizing changes
in the structure of the economy as well, in line with the prediction of the famous Lucas (1976) critique
that economic structure depends on the policy regime. High and unstable inflation increases the
variability of relative prices and real interest rates, for example, distorting decisions regarding
consumption, capital investment, and inventory investment, among others. Likewise, the high level,
variability, and unpredictability of inflation profoundly affected decisions regarding financial
investments and money holdings. Theories of "rational inattention" (Sims, 2003), according to which
people vary the frequency with which they re-examine economic decisions according to the underlying
economic environment, imply that the dynamic behavior of the economy would change - probably in
the direction of greater stability and persistence - in a more stable pricing environment, in which
people reconsider their economic decisions less frequently.
Second, changes in monetary policy could conceivably affect the size and frequency of shocks hitting
the economy, at least as an econometrician would measure those shocks. This assertion seems odd
at first, as we are used to thinking of shocks as exogenous events, arising from "outside the model," so
to speak. However, econometricians typically do not measure shocks directly but instead infer them
from movements in macroeconomic variables that they cannot otherwise explain. Shocks in this sense
may certainly reflect the monetary regime. For example, consider the cost-push shocks that played
such an important role in 1970s' thinking about inflation. Seemingly unexplained or autonomous
movements in wages and prices during this period, which analysts would have interpreted as shocks
to wage and price equations, may in fact have been the result of earlier monetary policy actions, or
(more subtly) of monetary policy actions expected by wage- and price-setters to take place in the
future. In an influential paper, Robert Barsky and Lutz Kilian (2001) analyze the oil price shocks of the
1970s in this spirit. Barsky and Kilian provide evidence that the extraordinary increases in nominal oil
prices during the 1970s were made feasible primarily by earlier expansionary monetary policies rather
than by truly exogenous political or economic events.
Third, monetary policy can also affect the distribution of measured shocks by changing the sensitivity
of pricing and other economic decisions to exogenous outside events. For example, significant
movements in the price of oil and other commodities continued to occur after 1984. However, in a
low-inflation environment, with stable inflation expectations and a general perception that firms do not
have pricing power, commodity price shocks are not passed into final goods prices to nearly the same
degree as in a looser monetary environment. As a result, a change in commodity prices of a given size
shows up as a smaller shock to output and consumer prices today than it would have in the earlier
period. Likewise, there is evidence that fluctuations in exchange rates have smaller effects on
domestic prices and economic activity when inflation is less volatile and inflation expectations are
stabilized (Gagnon and Ihrig, 2002; Devereux, Engel, and Storgaard, 2003).
Fourth, changes in inflation expectations, which are ultimately the product of the monetary policy
regime, can also be confused with truly exogenous shocks in conventional econometric analyses.
Marvin Goodfriend (1993) has suggested, for example, that insufficiently anchored inflation
expectations have led to periodic "inflation scares", in which inflation expectations have risen in an
apparently autonomous manner. Increases in inflation expectations have the flavor of adverse
aggregate supply shocks in that they tend to increase the volatility of both inflation and output, in a
combination that depends on how strongly the monetary policymakers act to offset these changes in
expectations.
Theoretical and empirical support for the idea that inflation expectations may become an independent
source of instability has grown in recent years.12 As I mentioned earlier, a number of researchers have
found that the reaction of monetary policymakers to inflation has strengthened, in that the estimated
coefficient on inflation in the Taylor rule has risen from something less than 1 before 1979 to a value
significantly greater than 1 in the more recent period. If the policy interest rate responds to increases in
inflation by less than one-for-one (so that the real policy rate does not rise in the face of higher
inflation), economic theory tells us that inflation expectations and the economy in general can become
unstable. The problem arises from the fact that, if policymakers do not react sufficiently aggressively to
increases in inflation, spontaneously arising expectations of increased inflation can ultimately be
selfconfirming and even self-reinforcing. Incidentally, the stability requirement that the policy rate respond
to inflation by more than one-for-one is called the Taylor principle (Taylor, 1993, 1999) - the third
concept named after John Taylor that has played a role in this talk. The finding that monetary
policymakers violated the Taylor principle during the 1970s but satisfied the principle in the past two
decades would be consistent with a reduced incidence of destabilizing expectational shocks.13
Support for the view that inflation expectations can be an independent source of economic volatility
has also emerged from the extensive recent literature on learning and macroeconomics (Evans and
Honkopohja, 2001). For example, Athanasios Orphanides and John C. Williams (2003a, 2003b) have
studied models in which the public must learn the central bank's underlying preferences regarding
inflation by observing the actual inflation process.14 With learning, inflation expectations take on a
more adaptive character; in particular, high and unstable inflation will beget similar characteristics in
the pattern of inflation expectations. As Orphanides and Williams show, when inflation expectations
are poorly anchored, so that the public is highly uncertain about the long-run rate of inflation that the
central bank hopes to achieve, they can become an additional source of volatility in the economy. An
analysis that did not properly control for the expectational effects of changes in monetary policy might
incorrectly conclude that the Taylor curve had shifted in an adverse direction.
Conclusion
The Great Moderation, the substantial decline in macroeconomic volatility over the past twenty years,
is a striking economic development. Whether the dominant cause of the Great Moderation is structural
change, improved monetary policy, or simply good luck is an important question about which no
consensus has yet formed. I have argued today that improved monetary policy has likely made an
important contribution not only to the reduced volatility of inflation (which is not particularly
controversial) but to the reduced volatility of output as well. Moreover, because a change in the
monetary policy regime has pervasive effects, I have suggested that some of the effects of improved
monetary policies may have been misidentified as exogenous changes in economic structure or in the
distribution of economic shocks. This conclusion on my part makes me optimistic for the future,
because I am confident that monetary policymakers will not forget the lessons of the 1970s.
I have put my case for better monetary policy rather forcefully today, because I think it likely that the
policy explanation for the Great Moderation deserves more credit than it has received in the literature.
However, let me close by emphasizing that the debate remains very much open. Although I have
focused on its strengths, the monetary policy hypothesis has potential deficiencies as well. For
example, although I pointed out the difficulty that the structural change and good-luck