Marcus Nunes reviews some empirical data from the Great Moderation:

Almost 16 years ago I wrote a paper: “Are_analysts_missing_the_point“; that inter alia tried to probe explanations for the increased economic stability since the early 1980´s. A surprising result was to discover, contrary to the idea mentioned in Taylor´s “The Long Boom that after 1983 the Fed reacted more strongly to inflation, that in fact the opposite is evidenced, with the FF rate showing no significant response to inflation.

The reason, according to Nunes, is that inflation showed less persistence during the Great Moderation:

One plausible explanation for the result that reconciles the (apparently contradictory) absence of response of the federal funds rate to inflation after 1982 with a postulated increase in the Fed.’s resolve to fight inflation is that the behavior of inflation changed after the 80/82 recession.

In fact, inflation after 1982 exhibits substantially less persistence than in the previous years (see figure below) so that increases in inflation in one month are viewed as temporary. In other words, inflation is much less auto correlated so that lagged values of inflation provide little information about future inflation. As a result, unexpected movements (or innovations) in inflation no longer require a monetary policy response (which sits well with the argument that the fed funds can be a poor indicator of monetary policy).

Why was inflation no longer persistent? Because it was due to supply shocks. Nunes explains and even quotes Bernanke:

One of the dangers associated with the absolute pursuit of “price stability” is the occurrence of supply shocks. This quote is from a Bernanke and Getler paper (my bold):

Macroeconomic shocks such as oil price increases induce a systematic (endogenous) response of monetary policy. We develop a VAR-based technique for decomposing the total economic effects of a given exogenous shock into the portion attributable directly to the shock and the part arising from the policy response to the shock. Although the standard errors are large, in our application, we find that a substantial part of the recessionary impact of an oil price shock results from the endogenous tightening of monetary policy rather than from the increase in oil prices per se.

Symmetrically, in the case of a positive supply (productivity) shock, a substantial part of the expansionary impact of the shock would result from the endogenous easing of monetary policy.

And what is the answer? Nunes explains:

According to the views of Market Monetarists, since a nominal GDP target ignores aggregate supply shocks it dominates an inflation target. It sees movements in the price level as a symptom of whatever underlying shock is taking place while regarding movements in nominal spending as an underlying shock itself – an aggregate demand shock – over which the Fed has direct influence and can respond to much more effectively. In essence, by not reacting to the “symptoms” and striving to keep AD stable, Fed policy would result in overall stabilization.

Bernanke should know better! Great post by Marcus.

(Thanks for the spelling suggestion Benjamin!)