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

The 1994-95 tightening episode was one of the most notable in the FOMC’s history because the FOMC raised the policy rate by 300 basis points in a year, despite headline and core CPI inflation trending lower prior to the beginning of tighter policy in February 1994. Although Chair Alan Greenspan publicly signaled the FOMC’s desire to normalize its policy rate prior to February 1994, the Federal Reserve’s actions nonetheless caught the Treasury market by surprise, triggering a sharp decline in long-term bond prices. Chair Greenspan and the FOMC 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 systematically, albeit modestly, overpredicted CPI inflation during the tightening period. Still, 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. The end result was the avoidance of a recession and an eventual slowing in inflation and inflation expectations.