After 1983, high, variable inflation gave way to low, stable inflation while real output became less variable. Section I advances the “inflation-fighter” explanation of this result. Inflation arose in the 1970s because the FOMC responded only halfheartedly to inflation shocks. The subsequent decline in real variability arose from a decline in inflation shocks.

Section II advances the “inflation-creator” view, which emphasizes how discretion in the 1970s destroyed nominal expectational stability. Subsequent rule-like behavior restored it. The resulting discipline imposed on funds rate changes caused the yield curve to move in a way that replaced the alternation of periods of contractionary and expansionary monetary policy with a neutral policy that turned economic stabilization over to the price system (Hetzel 2006). An appendix argues that the Taylor Rule fails to offer a useful framework for understanding monetary policy.

The Fed as Inflation Fighter

The inflation-fighter view is in a traditional Keynesian spirit, which emphasizes a Phillips curve with inertia in inflationary expectations that exists independently of monetary policy. This inertia, reflected in expectations based on realized inflation, propagates inflation shocks. Consistent with the belief that the FOMC can predictably manipulate real variables, inflation arises when the central bank fails to raise the real interest rate and the unemployment rate sufficiently to offset such shocks.

Blinder and Reis (2005, 16) exposit this view: