Risk Management in Monetary Policymaking: The 1994-95 Fed Tightening Episode

The 1994-95 Fed tightening episode was one of the most notable in the Fed’s history. First, the FOMC raised the policy rate by 300 basis points in a year, even though headline and core inflation were trending lower prior to the liftoff that occurred in February 1994. Second, the Fed’s actions caught the Treasury market by surprise, triggering a sharp decline in long-term bond prices. Third, Fed Chair Alan Greenspan and the Federal Open Market Committee were regularly surprised that inflation was not rising by more than the forecasts suggested during the episode. This article presents some evidence that the Greenbook forecast systemically, albeit modestly, overpredicted CPI inflation during the tightening period. Greenspan eventually concluded that the nascent strengthening in labor productivity growth that was a key factor in restraining the growth of unit labor costs, and thus in keeping inflation pressures in check. At the same time, the success of the episode stemmed importantly from the decision by Greenspan and the FOMC to increase the policy rate to a level deemed restrictive for most of 1995. This effort reduced longer-run inflation expectations without triggering a recession. By that metric the 1994-95 tightening episode was a roaring success. Although not the focus of this article, the 1994-95 tightening episode holds important lessons for the FOMC in late 2023, which is attempting to defuse a sharp and unexpected increase in headline and core inflation to levels not seen since the early 1980s without triggering a recession.