The Decline of Activist Stabilization Policy: Natural Rate Misperceptions, Learning, and Expectations

Natural rate misperceptions generated the potential of significant upward inflationary pressure in the late 1960s and 1970s. With the activist stabilization policy in place during this period, these misperceptions led to a series of persistent policy errors that inadvertently destabilized the economy and inflation expectations. We develop a model that highlights the interaction of these policy errors with an endogenous expectations formation process as the origin of the stagflationary episode of the 1970s. The experience of unexpectedly rising inflation in the late 1960s and early 1970s led agents to modify their views of the behavior of monetary policy and the economy, unmooring inflation expectations and significantly worsening policy options. The interaction of policy mistakes and learning turned what could have been a relatively mild inflationary episode into stagflation. By contrast, adoption of policies that downplay the activist pursuit of employment and output gaps would have avoided this outcome. We argue that out of the experience of the 1970s policymakers eschewed activist policies in favor of policies that concentrated on the achievement of price stability, resulting in the improved macroeconomic performance of the U.S. economy since the Great Inflation.