– December 8, 2014

Many economists argue the Fed can improve economic performance by moderating booms and busts in the economy. Indeed, some studies propose that the volatility of GDP growth has declined under the Fed, especially during the “Great Moderation” from the mid-1980s to the present day.

My recent paper “Has the Fed Improved U.S. Economic Performance?”, soon to be published in the Journal of Macroeconomics, explores this issue by analyzing economic performance in the Fed and pre-Fed periods in terms of the rates and volatilities of inflation and GDP growth.

For the Great Moderation, the results are consistent with the expectations of most economists. The volatilities of inflation and GDP growth have indeed declined since the mid-1980s. On the other hand, inflation has been higher, and real GDP growth has been lower, indicating that the Great Moderation has been worse on these criteria.

However, the “early postwar” period prior to the Great Moderation tells a different story. The table below summarizes the results comparing the period after World War II but before the Great Moderation to the pre-Fed periods before and after the Civil War. I classify the pre-Fed periods as better or worse that the early postwar Fed if the difference is statistically significant with a confidence level of 99%.

Period Years Average rate
of inflation
of inflation
Average GDP
Volatility of
GDP growth
State banking 1792-1865 Better Worse Better Same
National banking 1866-1913 Better Better Better Worse

As the table shows, the state banking period before the Civil War is better than the early postwar Fed in terms of low inflation and high GDP growth, but it no worse in terms of the volatility of GDP growth.

The national banking period is worse than the early postwar Fed in terms of higher GDP volatility, but the national banking period is better in terms of lower rates of inflation, lower volatility of inflation, and higher rates of real GDP growth.

There are two important implications from these results. First, any improvements in economic performance appear to have come mostly during the Great Moderation rather than the post-World War II period.

Second, other studies finding the Fed has reduced GDP volatility look only at the national banking period after the Civil War. The low GDP volatility in the state banking period indicates that those comparisons are biased or, at best, incomplete.

Given these results, those who favor the Fed might argue that the Great Moderation is more indicative of current Fed policy. However, there is still much debate over how large a role monetary policy played in creating the Great Moderation relative to other causes like improvements in information technology and inventory management and the lack of real shocks from oil prices or major wars. Economists also disagree over what policy the Fed should follow in terms of targeting inflation, nominal GDP, or a dual mandate like the Taylor Rule.

If economists cannot identify the factors that led to the Great Moderation or agree on a prescription for Fed behavior going forward, then it seems unlikely the Fed will be able to recreate the prosperity of the Great Moderation, if it did play a role in creating the Great Moderation at all.

Thomas L. Hogan

Thomas L. Hogan

Thomas L. Hogan, Ph.D., is a senior resident fellow at AIER. He was formerly the chief economist for the U.S. Senate Committee on Banking, Housing and Urban Affairs. His primary research interests include banking regulation and monetary policy.

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