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To Tame Inflation, the Fed Must Learn From Its Mistakes
The disastrous monetary policies of the 1970s are a useful cautionary tale
By Thomas Hoenig
The Federal Open Market Committee (FOMC) has delayed changing its highly accommodative monetary policy to ensure the economy fully recovers from the effects of the pandemic. However, it appears to have delayed too long, as the annual rate of inflation is now 7.9%, and even at this rate the Federal Reserve continues to grow its balance sheet and keep rates near zero. The Fed will be justly criticized for allowing inflation to move so far above its 2% target, because now the cost of containing inflation will be greater than Americans expect or desire.
The FOMC appears ready to combat inflation by ending its asset purchases and increasing interest rates. However, because of its delay, it has created a new dilemma: Should it increase rates aggressively to get in front of burgeoning inflation, which also increases the risk of a recession? Or should it remain cautious, increase rates slowly and be prepared to reverse course should a recession threaten? The choices are not unlike those that confronted the FOMC at the start of the 1970s. In that instance it followed the latter path with disastrous results. Thus, it may be worth looking back to find a better path forward.
The Starting Point
The pandemic inflicted a dramatic shock on the U.S. economy, devastating supply chains, destroying jobs and cratering aggregate demand. GDP collapsed by 10% between the first and second quarter of 2020. The unemployment rate increased from a low of 3.5% in January 2020 to more than 13% by May. Determined to avoid a paralyzing recession, the federal government and Fed acted swiftly and dramatically. The federal government provided approximately $5 trillion of COVID relief funds to businesses, small and large, and to individuals in the form of enhanced jobless benefits and child care and related credits. The FOMC, which had restarted quantitative easing at a pace of $60 billion per month in September 2019, doubled it to $120 billion per month in March 2020. This policy has continued for more than a year and a half beyond the start of the economic recovery, and it has caused the Fed to expand its balance sheet from an already high $4 trillion at the start of the pandemic to nearly $9 trillion currently. By comparison, in 2008 the Fed’s balance sheet was less than $1 trillion.
The policy had its intended effect. By the third quarter of 2020, U.S. GDP was back near pre-pandemic levels and by the end of 2021 was 23% higher than in March 2020. However, the economy recovered so strongly and swiftly that it brought with it significant inflation, which risks the very recovery that was sought. Asset inflation, which had been high for more than a decade, continued at double-digit rates, affecting housing, commercial real estate and the stock market. Price inflation, which had been below 2%, began to accelerate from a modest 1.4% in January 2021 to a 40-year high of 7.9%, well beyond the FOMC’s 2% target range.
For a good part of 2021, policymakers at the Department of the Treasury and the FOMC considered the inflation impulse to be temporary, caused by the pandemic and related supply chain disruptions. They also expected that price pressures would ease as the federal government ceased making direct payments of unemployment and other benefits to the public. However, these improvements have not occurred. Although supply channels are opening, demand continues to outstrip supply and inflation continues to increase. The situation is complicated further by the ongoing war in Ukraine and the imposition of global sanctions on Russia. Labor remains in short supply and wage rates are climbing. Thus, it is unlikely that consumer price inflation will return to pre-pandemic levels anytime soon.
Learning From the 2008 Financial Crisis
The FOMC, acknowledging that inflation is more embedded in the economy than originally thought, has announced that by the end of March 2022 it will cease buying government and mortgage-backed debt securities and will begin to raise interest rates. Despite this announced change, however, the Fed has also made clear that it will act cautiously, which seems like a certainty given its policy record over the past decade.
For example, after the financial crisis in 2009, it took the FOMC six years to raise the federal funds rate and reduce the size of the reserve banks’ balance sheet from its historic high of more than $4.5 trillion. At the end of 2018, a decade after the crisis, the federal funds rate remained relatively low at 2.25%, and the balance sheet was nearly $4 trillion.
Then, in September 2019, although the economy was growing strongly, short-term market interest rates spiked as banks held back funds from the repo market (bank loans secured with government securities). The FOMC, fearing a shock to the economy, abandoned plans to shrink its balance sheet further and instead began buying $60 billion worth of securities per month to assure adequate liquidity within the market. Between September 2019 and March 2020, before the FOMC began to address the effects of the pandemic, the reserve banks’ balance sheet was again near $4.3 trillion.
FOMC policy actions from the 2008 financial crisis to the present have demonstrated the committee’s bias to ease policy quickly but tighten it slowly when there is uncertainty about the economy. Now, with inflation well above its target range and increasing, the FOMC faces a difficult choice. Should it act aggressively to contain inflation and risk a recession, or act cautiously and risk higher inflation in the hopes of avoiding a recession?
Learning From the High Inflation of the 1970s
As the FOMC entered the 1970s, it faced a similar set of choices as it does today. The 1970s followed a decade of highly expansionary fiscal and monetary policy. President Johnson had committed the U.S. to an expensive war in Vietnam while also pressing successfully for legislation to significantly increase social programs. As the graph below illustrates, by the end of the 1960s the U.S. inflation rate was above 5%. In reaction, the FOMC more than doubled the federal funds rate to 9% between the end of 1968 and the start of 1970. While inflation eventually declined to 3%, the economy soon entered a recession in which the unemployment rate increased to more than 6%.
In response, policymakers reversed course. Congress expanded government spending and accepted higher deficits. The FOMC lowered the federal funds rate by more than half, to below 4%. And between year-end 1971 and year-end 1972, the money supply increased at a rate of nearly 13%. GDP recovered, growing at a 2% rate, and unemployment declined to 5% by the end of 1973.
Also, during this expansionary period, the Nixon administration introduced wage and price controls as an alternative means to contain inflation. They apparently worked for a while, as inflation stayed below 3% and the unemployment rate declined from above 6% to just below 5%. However, once the controls were removed, prices again started their climb, aggravated by the supply shock of the 1973 OPEC oil embargo.
At the time of the embargo, the federal funds rate was less than 4%. Inflation, which had declined to 5%, now accelerated to over 12% by 1974. The Fed again reacted by increasing the federal funds rate to near 12% by mid-1974. The new Ford administration also initially promised to reduce spending and increase taxes. These actions brought inflation below 5% in 1976. However, as if on cue, the economy entered a recession in which the unemployment rate nearly doubled from less than 5% to 9% in 1976, and policy again reversed. Fiscal policy went from tax increases to tax cuts, and government spending increased. The FOMC lowered the federal funds rate to less than 5%, where it remained for more than two years. While the fiscal stimulus and lower federal funds policy rate reduced unemployment to 5.5%, inflation accelerated from an already high 6% to nearly 14% by the end of the decade.
In the end, the irresolute policies of the 1970s achieved neither low unemployment nor low inflation. After each cycle of loosening and then tightening policy, both inflation and unemployment settled at new highs. By the end of the decade, inflation was 14% and unemployment more than 10%. Only when Paul Volcker took the reins of the FOMC did the stop-go monetary policies of the ’70s finally came to an end. It required a resolute policy of higher interest rates and an unavoidable and difficult recession, but inflation was brought down from 14% to less than 6% and did not rise above that lower rate until 2021.
The Future of FOMC Policy
With inflation running again at historic highs, the FOMC has signaled it will end its expansionary policies in March. At this stage, that is the easiest policy decision to make. The more difficult decision is how to balance the goal of returning the economy to a 2% inflation target against the likely increase in unemployment that might follow a series of rate hikes.
If unemployment increases, the public will be alarmed. Politicians will seek to expand fiscal policy and will apply enormous pressure on the FOMC to reverse its policy and lower interest rates. Given its track record, the FOMC could very well slow or reverse its policy path as it did in the ’70s. That would be a mistake. The FOMC must state firmly its commitment to lowering inflation and acknowledge that unemployment may temporarily increase. If it allows itself to be pulled into the stop-go policies of the ’70s, it will get the worst of both inflation and unemployment.
In the drive to achieve price stability and stable growth, monetary policy is a powerful tool. Lowering interest rates is the standard monetary policy response to the onset of an economic recession and rising unemployment. But it is a blunt instrument, and when implemented at an extreme level, as it has been throughout the past decade, it invites unintended consequences, including misallocation of precious resources, inflation, financial crisis and unemployment.
Thus, in implementing its next phase of policy, the FOMC must plan for a long-term adjustment. It can be cautious, but it must be deliberate in its policy to contain inflation as it strives to avoid a debilitating recession. Should the FOMC choose to repeat the policies of the ’70s or return to those of the past decade, the likely outcome will be economic crisis and lost wealth for the next generation of Americans.