Deflation or inflation prevailed during most of the 65 years following the establishment of the Fed. Instability in the real economy accompanied monetary instability. In contrast, starting after the Volcker disinflation, low, stable inflation accompanied considerable real stability. An understanding of these outcomes requires a combination of knowledge about the way that monetary policy evolved and of theory. The evolution of monetary policy reflects an increased assumption over time by the Fed of a responsibility for actual and expected inflation. The theory assumes that actual and expected inflation are monetary phenomena shaped by the systematic part of central bank procedures. Also, in the absence of central bank behavior that makes the price level evolve unpredictably, the price system works well to maintain macroeconomic equilibrium.

Three lessons emerge: (1) Inflation is a monetary phenomenon whose behavior is determined by the central bank. (2) Central bank credibility evidenced by stability in expected inflation is central to inflation stability. (3) The central bank must allow the price system to work. These lessons provide the foundation for understanding monetary policy in the V–G era as rule-like behavior that disciplined the lean-against-the-wind character of funds rate changes to ensure that macroeconomic shocks left actual and expected trend inflation unchanged.

A Nominal Anchor Lost and Regained

For the founders of the Fed, who took the gold standard for granted without understanding it, the marketplace determined the price level.