I see three key parallels between the economic situation in 1979 and the economic situation in 2013. First, just like in 1979, the Federal Open Market Committee faces a challenging macroeconomic problem—although this time, the problem is stubbornly low employment as opposed to stubbornly high inflation. Second, there is a widespread perception that monetary policymakers lack either the tools or the will to solve this problem.

And third, the perception of monetary policy ineffectiveness is itself a key factor in generating the problem… If the public thinks that monetary policy is ineffective, then it will expect relatively weak macroeconomic conditions in the future. But these expectations about the future have a direct impact on current macroeconomic outcomes…

We’ve seen how the FOMC dealt with its problems in 1979 by adopting a goal-oriented approach to monetary policy. Given the parallels between 1979 and 2013, I believe that a goal-oriented approach would be useful again…

But, as Paul Volcker said in his 1979 speech, it is not enough to formulate or communicate a goal. The Committee has to stick to its formulated approach—that is, it must do whatever it takes to achieve its communicated goal. In the early 1980s, doing whatever it took meant being willing to keep money tight, even though interest rates and the unemployment rate rose to unusual heights. By doing whatever it took to achieve its goal, despite these short-term costs, the FOMC was able to bring down inflation and inflation expectations.

The title of my speech today is “A Time of Testing.” Paul Volcker, then Chairman of the Federal Reserve Board of Governors, used the same title for a speech that he gave on October 9, 1979. Chairman Volcker intended his title to underscore that monetary policymakers in 1979 were confronted with a severe test in the form of high inflation and high inflation expectations. I use the title today to underscore that monetary policymakers in 2013 are again confronted with a severe test—but this time a test created by low employment and low employment expectations. Back in 1979, Chairman Volcker said that “this is a time of testing—a testing not only of our capacity collectively to reach coherent and intelligent policies, but to stick with them”1 [italics mine]. My theme today is that his powerful phrase applies with equal force to our current situation.

I think we will probably have to begin raising rates sometime in the not-too-distant future...I also don't want to repeat the Great Inflation of the 1970s.

As reported by The Wall Street Journal and Dow Jones Newswires.

I want to make clear that the rise in inflation expectations in the 1970s was not caused by a wage-price spiral. That story has things backwards. The wage-price spiral was a consequence of the inflation and the unanchoring of expectations of inflation, not the other way around. And the unanchoring of inflation expectations was caused by the public’s loss of confidence in the Federal Reserve’s resolve to bring inflation back down. The credibility of the Fed’s promise to deliver price stability was lost.
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I want to emphasize that what we have been seeing in the economy this past year, and in my own outlook going forward, is very different from the 1970s, because I see the Fed as committed to keeping inflation expectations well-anchored. I agree with a statement Fed Chairman Bernanke made in June that the Fed will strongly resist an erosion of longer-term inflation expectations, because an “unanchoring” of those expectations would be destabilizing for economic growth as well as inflation.

Economists generally agree that monetary policy performed poorly during {the 1970s}.  In part, this was because policymakers, in choosing what they believed to be the appropriate setting for monetary policy, overestimated the productive capacity of the economy. I'll have more to say about this shortly. Federal Reserve policymakers also underestimated both their own contributions to the inflationary problems of the time and their ability to curb that inflation. For example, on occasion they blamed inflation on so-called cost-push factors such as union wage pressures and price increases by large, market-dominating firms; however, the abilities of unions and firms to push through inflationary wage and price increases were symptoms of the problem, not the underlying cause.  Several years passed before the Federal Reserve gained a new leadership that better understood the central bank's role in the inflation process and that sustained anti-inflationary monetary policies would actually work. Beginning in 1979, such policies were implemented successfully--although not without significant cost in terms of lost output and employment--under Fed Chairman Paul Volcker.  For the Federal Reserve, two crucial lessons from this experience were, first, that high inflation can seriously destabilize the economy and, second, that the central bank must take responsibility for achieving price stability over the medium term.

From the perspective of monetary policy, just as important as the behavior of actual inflation is what households and businesses expect to happen to inflation in the future, particularly over the longer term.  If people expect an increase in inflation to be temporary and do not build it into their longer-term plans for setting wages and prices, then the inflation created by a shock to oil prices will tend to fade relatively quickly. Some indicators of longer-term inflation expectations have risen in recent months, which is a significant concern for the Federal Reserve.  We will need to monitor that situation closely. However, changes in long-term inflation expectations have been measured in tenths of a percentage point this time around rather than in whole percentage points, as appeared to be the case in the mid-1970s. Importantly, we see little indication today of the beginnings of a 1970s-style wage-price spiral, in which wages and prices chased each other ever upward.

The oil price shock of the 1970s began in October 1973 when, in response to the Yom Kippur War, Arab oil producers imposed an embargo on exports. Before the embargo, in 1972, the price of imported oil was about $3.20 per barrel; by 1975, the average price was nearly $14 per barrel, more than four times greater. President Nixon had imposed economy-wide controls on wages and prices in 1971, including prices of petroleum products; in November 1973, in the wake of the embargo, the President placed additional controls on petroleum prices.²

As basic economics predicts, when a scarce resource cannot be allocated by market-determined prices, it will be allocated some other way--in this case, in what was to become an iconic symbol of the times, by long lines at gasoline stations. In 1974, in an attempt to overcome the unintended consequences of price controls, drivers in many places were permitted to buy gasoline only on odd or even days of the month, depending on the last digit of their license plate number. Moreover, with the controlled price of U.S. crude oil well below world prices, growth in domestic exploration slowed and production was curtailed--which, of course, only made things worse.

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Fast-forward now to 2003. In that year, crude oil cost a little more than $30 per barrel.³ Since then, crude oil prices have increased more than fourfold, proportionally about as much as in the 1970s.  Now, as in 1975, adjusting to such high prices for crude oil has been painful. Gas prices around $4 a gallon are a huge burden for many households, as well as for truckers, manufacturers, farmers, and others. But, in many other ways, the economic consequences have been quite different from those of the 1970s. One obvious difference is what you don't see: drivers lining up on odd or even days to buy gasoline because of price controls or signs at gas stations that say "No gas." And until the recent slowdown--which is more the result of conditions in the residential housing market and in financial markets than of higher oil prices--economic growth was solid and unemployment remained low, unlike what we saw following oil price increases in the '70s.

The 1970s were a horrible period. If there's one thing that has to be very high priority, we don't want to go back to a period that is anything like that.

As reported by Reuters

We have had this financial crisis; I think on balance as we at the Federal Reserve have provided liquidity to the marketplace, it's my thought that we have stabilized things.

This allows the other policy choices, the tax cut ... monetary policy that's in place, to strengthen the economy as it goes through the course of the year. And in that context then, our big challenge will be to make sure that we bring inflation in check and make sure that we do not repeat some of the experiences we had in the late 70s and early 80s when inflation became far too high.

As reported by Reuters.

But what concerns me about the present situation, of course it's very difficult. But I've reached a certain age where I can remember quite a few things, and there are some resemblances between the present situation and the period in the early 1970's, not in the late 1970's when inflation really got started.

On your second concern, I think we're better off now than we were in the '70s, in that there's a much broader recognition of the important of price stability and greater confidence that central banks will deliver price stability.

     The indicia of inflation expectations, where some of them have moved a bit, are basically stable. We have not seen any major shift in views about inflation and where inflation's likely to go.

     The Federal Reserve has emphasized the importance of maintaining price stability and has indicated that we will watch very carefully to make sure that we don't see any deterioration in either broad measures of inflation expectations or increased pass-through of food and energy prices into other prices. We will watch those carefully and we will respond.

 Likewise, a lower sensitivity of long-run inflation to supply shocks would imply that such shocks are much less likely to generate economic instability today than they would have been several decades ago. Notably, the sharp increases in energy prices over the past few years have not led either to persistent inflation or to a recession, in contrast (for example) to the U.S. experience of the 1970s.

We cannot afford to go back to a world similar to the 1970s, where shocks that should have had only a transitory impact on inflation—whether due to oil prices, rents or movements in the dollar—shift longer-term inflation expectations and touch off a self-fulfilling wage-price spiral. The Fed’s commitment over the last two decades to keeping inflation low has fundamentally changed inflationary psychology and that has permitted both inflation and unemployment to be low and stable. Keeping inflationary expectations well anchored is essential to good outcomes for the economy overall.

On the other hand, as Christy and David Romer (2002) have pointed out, the Federal Reserve in the 1970s overestimated the cost of reducing inflation because estimates of sacrifice ratios by Arthur Okun and other economists at that time proved to be too high.¹² As a historical note, this provides one explanation for the Federal Reserve’s tolerance of such high inflation at the time. The disinflation after October 1979, carried out by the Federal Reserve under the leadership of Paul Volcker using words, procedures, and actions that were a sharp break from the past, produced a much lower cost of disinflation than policymakers had anticipated during the 1970s.

Policymakers in the 1970s--the Federal Reserve among them--were dealt a very bad hand that, for a variety of reasons, they played poorly.

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Not only were the output costs of disinflation seen to be high but also the monetary policy needed to bring inflation down was consistently miscalculated--economists during the 1970s persistently overestimated both the speed and magnitude of the slowdown in real activity and inflation that would result from a given rise in the federal funds rate. Part of this miscalculation reflected a judgment that the economy and financial markets were fragile and that small changes in market interest rates would have major effects on aggregate spending (for example, as a result of disintermediation induced by ceilings on the interest rates that banks and thrifts could pay).