Since the Federal Reserve began taking a more active role in regulating aggregate demand during World War II, it has lowered its price stability aim and shifted its emphasis toward employment and higher inflation.
Inflation is at a forty-year high and accelerating, and the Federal Reserve now faces the tough task of tightening monetary policy sufficiently to bring inflation down to goal while avoiding recession. With all of its experience, how did the Fed get itself in this situation? Regrettably, delayed withdrawals from countercyclical monetary easing have been a recurrent trend throughout contemporary US history.
Since the Federal Reserve began taking a more active role in regulating aggregate demand during World War II, it has lowered its price stability aim and shifted its emphasis toward employment and higher inflation. The Fed's discretionary approach has required it to continuously reinterpret its objectives and increase the monetary instruments available to accomplish them. This has necessitated excessive fine-tuning of economic outcomes without respect for the delays between monetary policy, the economy, and inflation, as well as periodic slippages in its drive to make monetary policy data-dependent.
Historically, the Fed appears to have exhibited the all-too-human tendency of "fighting the last battle": basing policies on the most recent cyclical policy reaction and outcome. As a result, the Fed routinely misinterprets history's most pertinent lessons.
We examine historical examples of the Fed exiting following periods of monetary easing that led in unwelcome inflation and subsequent tightening stages in this article. These include the post–World War II period, the 1960s and 1970s, the early 1990s, the 2002–6 period, the post–2008–9 financial crisis period, and the current pandemic period. While each inflation event evolved differently, we discover that they were always triggered by some combination of monetary and fiscal stimulation that created excess demand. Each event demonstrated that the Fed was too sluggish to unwind its monetary stimulus, hence stoking inflation. Fed tightening that followed is generally associated with recession.
Our findings contradict the Biden administration's Council of Economic Advisers' judgment, which attributed these episodes of inflation to supply shocks and a number of other causes but not to the stimulative effects of monetary and fiscal policy. Similarly, as inflation increased last year, the Fed maintained that it was the result of supply shocks, drastically understating the importance of monetary and fiscal policy stimulus in driving aggregate demand. In December 2021, the Fed finally acknowledged the continuance of inflation and the necessity for the Fed to boost interest rates to curb demand.
Michael Bordo and John Landon-Lane meticulously chronicled the cyclical events from the 1920s. Their narratives and empirical data indicate that, up to the 1950s, the Fed began raising rates in response to an increase in the general price level. Since the 1960s, the Fed has frequently tightened following the onset of inflation, and its late departures to reverse the inflation have resulted in recession.
Unless the Fed corrects its unbalanced approach to meeting its employment and inflation objectives and recognises the delays between monetary policy, the real economy, and inflation, it will continue to make policy errors in the future. This remedy entails eliminating the inequalities and imbalances generated by the Fed's new strategic framework and replacing it with a rule-based approach to maximizing employment that gives the Fed with appropriate flexibility in times of emergency.
Inflation during the modern era of the United States of America
Following World War II. The post-World War II inflationary period bears significant parallels to today. Prior to the 1951 Treasury-Fed Accord, the Fed aided the Treasury in financing World War II by maintaining artificially low interest rates and fast money expansion. Following the war's conclusion and the Great Depression, it was widely recognized that the government's primary job should be to manage aggregate demand. The primary risk was that aggregate demand would fall, resulting in recession and deflation, as occurred during World War I.
Rather than that, pent-up demand rose, spurred by the Fed's inability to raise interest rates. Consumption and housing both increased significantly, as did company investment. Excess demand for commodities hampered the transition from military to civilian manufacturing and increased production costs. After the wartime wage-price limitations were abolished, businesses profited from increased demand and increased product prices. Temporary but severe inflation followed the lifting of wartime pricing restrictions, with three consecutive years of inflation surpassing 10%.
The Fed tightened monetary policy late in the game by increasing bank capital and reserve requirements, as defense expenditure declined faster than expected and fiscal policy became restrictive. This resulted in a modest recession in 1949, which rapidly brought inflation under control. This episode focused on two recurring topics. To begin, monetary stimulus has a delayed effect on aggregate demand. Second, once inflation reaches a certain level, it is difficult to bring it back down without jeopardizing economic expansion.
Late 1960's. Following a decade of relatively low inflation before to 1965, inflation surged rapidly in the second half of the decade, from 1.6 percent in 1965 to 5.9 percent in 1970. Excessive fiscal stimulus—President Johnson's Great Society initiatives and Vietnam War spending—combined with loose monetary policy resulted in excess demand and inflation. By the 1960s, activist Keynesianism had gained widespread acceptance. Priority was given to reducing unemployment, and the assumption that moderate inflation was beneficial to economic performance dominated policymakers' thinking.
Although increased government spending encouraged demand, the Fed succumbed in late 1965 to LBJ's requests not to raise interest rates, much to the chagrin of fiscally conservative Fed head William McChesney Martin. In the summer of 1966, the Fed sought to cool aggregate demand by increasing bank capital requirements and without relaxing Regulation Q on interest rates. As a result, a "credit crisis" occurred, momentarily halting economic activity and compelling the Fed to take a step back. Accelerated Vietnam War spending and the reintroduction of monetary accommodation boosted aggregate demand and inflation. Only after LBJ declared his decision not to seek re-election did the Martin-led Fed begin rapidly hiking rates. In 1970, the economy entered a minor recession as a result of the prolongation of the Vietnam War surtax.
1970s. Following the 1970 recession, inflation fell to 3.5 percent, more than double the average for 1965, and inflationary expectations remained robust. Arthur Burns, the new Fed chairman, expressed greater worry about the high unemployment rate, which increased from 4.2 percent in February 1970 to 6.1 percent in December. Burns ascribed inflation to a variety of non-monetary forces, including labor unions and greedy firms, rather than to Fed policy, reflecting his varied views and mistrust of monetary policy. This resulted in his disastrous support for President Nixon's wage and price restrictions, as well as the gold standard's demise.
Among the numerous lessons learned from the 1970s' misguided policies and high inflation is that wage and price controls were destructive in numerous ways, addressing the symptoms of inflation rather than its causes, underplaying the role of inflationary monetary policy, and sowing widespread confusion. In August 1971, the gold standard was abandoned, unmooring inflationary expectations. During Nixon's re-election campaign, the Fed's expansive monetary policy generated inflation pressures that were restrained by wage and price controls. High inflationary expectations subsequently got ingrained in wage and price setting behavior, driving interest rates higher and wreaking havoc on financial markets.
Although the oil price shocks of November 1973 and 1979 led to inflation and bad economic performance, these negative supply shocks would not have caused prolonged excess demand and inflation in the absence of supportive monetary policy. Following a brief increase in nominal expenditure, aggregate demand and inflation would have decreased. Rather than that, nominal GDP growth surpassed 10% in every year from 1978 to 1981, generating the extra demand that powered the wage-price spiral.
Finally, the 1970s saw a decade-long policy shift toward promoting reduced unemployment while relying on unsuccessful administrative measures to contain inflation in the absence of a credible method for doing so. These activities weakened public and financial market trust and resulted in the US currency crisis of 1978. The Volcker-led Fed's prudent and necessary disinflationary actions ended inflation, and inflationary expectations contributed to painful recessions in 1980–82, but also ushered in a protracted period of moderate inflation and robust economic performance.
1990s. The 1990s were highlighted by one of the Fed's greatest successes: a mid-cycle monetary tightening in 1994 that resulted in an economic soft landing and lower inflationary expectations, laying the groundwork for the second half of the decade's solid economic performance.
During the so-called "jobless rebound" that followed the short recession of 1990, the Fed maintained monetary accommodation. The Fed hiked rates rapidly in reaction to the economic overheating that began in 1993, from 3% in February 1994 to 6% a year later.
While this successfully reduced inflationary expectations and staged an economic soft landing, the rapid rate increases were not without consequence. Domestically, increases in Treasury and mortgage rates led in the bankruptcy of numerous public sector money managers in the United States. Significantly, the Fed rate rises exacerbated Mexico's debt and peso devaluation problem (dubbed the "tequila crisis"), which reverberated across Latin America.
The twenty-first century. The adverse consequences of rate rises in 1994 had a significant influence on the Greenspan-led Fed. In 1999, despite an overheated economy and the dot-com stock market bubble, the Fed maintained monetary accommodation because it incorrectly focused on keeping surplus liquidity moving into 2000. Then it overtightened monetary policy. In 2001, the stock market bubble burst, precipitating a recession that culminated in the shock of the 9/11 terrorist attacks. Following 9/11, the Fed had a new concern: inflation had fallen to 1%, and the Fed feared that the US might follow Japan's 1990s path of deflation, plunging the country into a downward spiral of weak aggregate demand from which escape would be impossible. Fed chairman Greenspan defined deflation as a low-probability but high-cost scenario and shifted monetary policy decisively in the other direction, while Fed governor Bernanke detailed how the Fed could battle deflation through asset purchases if it encountered the zero lower limit.
Even as inflation accelerated to 2%, the Fed maintained a 1% policy rate, and when it finally began raising rates in response to the jarring effects of the mid-1990s rapid rate increases, the Fed provided advance warning of very gradual increases with the explicit goal of minimizing financial market disruption. For an extended period, rates remained far lower than what a Taylor-type monetary policy rule would have suggested, while real estate activity, prices, and mortgage debt skyrocketed.
While the Fed's actions did not directly contribute to the debt-financed housing bubble, which was defined by the growth of overly complex mortgage-based financial instruments, the Fed's lower-for-longer monetary policy undoubtedly aided the debt-financed housing boom. Subsequent rate rises in 2005–6 altered house expectations and destabilized the mortgage loan markets. This ultimately resulted in the financial disaster. This was another instance of the Fed's tardy withdrawal from monetary easing becoming expensive.
Following the Global Financial Crisis (GFC). The Fed's persistent aggressive monetary easing was remarkable in its character and impact, with significant long-run consequences. The Fed responded to the November 2008 crisis with QE2, "Operation Twist" (short-dated securities were sold and long-dated securities were purchased), and open-ended QE3. Bernanke emphasized that the fundamental objective of QE3 was to reduce unemployment. The Fed then maintained zero interest rates until December 2015, far after the economy had fully recovered. While the economy progressively recovered from the Great Financial Crisis and labor markets gradually improved, inflation remained moderate and well below the Federal Reserve's longer-run objective of 2%. From December 2015 to September 2018, the Fed progressively increased rates to 2.5 percent, somewhat higher than inflation. While this unsettled financial markets, the economy continued to develop and the Fed averted recession. The Fed's policy reaction to the 2020 pandemic was strongly impacted by the extended mild growth that followed the financial crisis.
The Fed drew the incorrect conclusions from this instance. Inflation remained low because the Fed's massive monetary easing beginning in 2009 failed to drive aggregate demand, with nominal GDP never exceeding 4%, giving little support for increasing prices and wages. Economic and financial conditions deteriorated, with a devastated banking system and housing industry, and shaky household finances that took years to mend. The American Recovery and Reinvestment Act of 2009 offered just a temporary boost, and January 2013 tax rises enforced budgetary restraint.
In this setting, the Fed's quantitative easing increased bank reserves and the monetary base, but these higher reserves remained excess reserves and did not transfer into an expanded money supply or credit growth that stimulated economic activity. This might be because the Fed began paying interest on excess reserves in October 2008, increased capital and liquidity requirements, and tightened controls and oversight of major banks as part of its stress testing. The Fed's 2018–19 strategic review, which focused on low inflation and concerns about the effective zero lower limit, did not properly examine why monetary policy fell short of the Fed's 2% inflation objective.
The pandemic of 2020 and now. In reaction to the looming severe economic recession and market dysfunction in the US Treasury market, the Fed cut interest rates to zero and embarked on a major asset acquisition program, including mortgage-backed securities. The Federal Reserve's initiatives were accompanied by the greatest fiscal stimulus program in American history. Financial markets immediately steadied, and signs of economic recovery began to emerge in May 2020. The government responded with increasing stimulus, totaling nearly $5 trillion in deficit expenditure, or more than 25% of GDP. For over two years, the Fed has maintained zero interest rates while more than doubling its balance sheet to $8.9 trillion through asset purchases.
The Fed made it quite plain that a fundamental lesson learned from the Great Financial Crisis was that its monetary reaction had been too cautious, and it assumed that the low inflation that followed the GFC would be replicated. This presupposition enabled the Fed to pursue its objective of maximum employment vigorously. The new strategic framework for the Federal Reserve, which Chairman Powell unveiled in August 2020, codified the Fed's uneven approach to monetary policy, prioritizing maximum employment and overtly supporting greater inflation. The Fed took its conclusion that the Phillips Curve was flat as implying that there was no reason to tighten monetary policy in advance of reaching maximum employment.
The Fed's assumptions and predictions turned out to be incorrect. The economy and labor market recovered substantially more quickly than the Fed anticipated, and inflation increased far beyond the Fed's December 2020 prediction of 1.8 percent in 2021. Even as the recovery gained momentum, the Fed stressed the adverse economic risks and maintained that the high inflation was temporary. It mistakenly ascribed inflation to supply constraints, while largely overlooking healthy aggregate demand and underestimating the impact of its forceful monetary stimulus. The Fed later retracted this remark.
Before the Fed announced in December 2021 that it would need to raise rates in 2022, consumer price index inflation had climbed to 6.9 percent and personal consumption expenditure inflation to 5.7 percent. By that time, the Fed's tardy withdrawal had pushed monetary policy far behind the curve.
Without a doubt, the epidemic posed unique dangers to the Fed. However, its current state is not unprecedented. Rather than that, it is a regrettable repetition of a historical pattern of delayed departures from sustained monetary relaxation.