Inflation is at a forty-year high and gaining momentum, and the Federal Reserve is now faced with the difficult challenge of tightening monetary policy enough to reduce inflation back to target, but not too much to generate recession. With so much experience, how did the Fed get itself into such a situation? Unfortunately, delayed exits from periods of countercyclical monetary easing have been a recurring theme in modern US history.
Since the Fed assumed a more active role in managing aggregate demand after World War II, it has downgraded its price stability objective and tilted toward prioritizing employment and favoring higher inflation. The Fed’s discretionary approach has involved constantly changing its interpretations of its objectives and expanding the monetary tools to achieve them. This has involved excessively fine-tuning economic outcomes without adequate regard to the lags between monetary policy, the economy, and inflation, and occasional slippages in its effort to make monetary policy data-dependent.
History suggests that the Fed has been guilty of the all-too-human trait of “fighting the last battle”: basing policies on the most recent cyclical policy response and outcome. This has led the Fed to frequently misinterpret the most appropriate lessons of history.
In this essay we review historic episodes of the Fed’s exits after periods of monetary ease that resulted in undesired inflation and subsequent tightening phases. These include the post–World War II period; the 1960s and 1970s; the early 1990s; the 2002–6 period; the period following the 2008–9 financial crisis; and the current pandemic period. While every episode of inflation unfolded under different circumstances, we find that all were initiated by some combination of monetary and fiscal stimulus that generated excess demand. In each episode, the Fed proved too slow to remove its monetary stimulus, fueling inflation. The subsequent Fed tightening typically generated recession.
Our findings contrast with the assessment of the Biden administration’s Council of Economic Advisers, which attributes these bouts of inflation to supply shocks and a variety of other factors but not to the stimulative impacts of monetary and fiscal policies. Similarly, as inflation rose last year, the Fed asserted that inflation was due to supply shocks while significantly understating the role of monetary and fiscal policy stimulus on aggregate demand. The Fed belatedly pivoted in December 2021 toward acknowledging the persistence of inflation and the need for the Fed to raise rates to slow demand.
The cyclical experiences since the 1920s were carefully documented by Michael Bordo and John Landon-Lane. Their narratives and empirical evidence found that up until the 1950s, the Fed began to raise rates after the general price level turned up. Since the 1960s, the Fed has often tightened after inflation has begun rising, and its belated exits to remove the inflation have led to recession.
Unless the Fed corrects its unevenly balanced approach to achieving its employment and inflation mandates and acknowledges the lags between monetary policy, the real economy, and inflation, it will be prone to future policy mistakes. This correction requires removing the asymmetries and imbalances introduced in its new strategic framework and replacing that framework with a rule-based approach for achieving maximum employment that provides sufficient flexibility to the Fed during emergencies.
Inflation in modern US history
Post–World War II. The high inflation that followed World War II has important analogies to today. Before the Treasury-Fed Accord of 1951, the Fed supported the Treasury’s financing of World War II with artificially low rates and rapid money growth. As the war ended and on the heels of the Great Depression, it was widely agreed that managing aggregate demand was the proper role of the government. The biggest concern was that aggregate demand would collapse and recession and deflation would follow, as during the period after World War I.
Instead, pent-up demand surged, fueled by sustained low interest rates and monetary ease, as the Fed was constrained from raising interest rates. Consumption and housing boomed and business investment surged. The excess demand for goods strained the transition from wartime to civilian production and drove up production costs. Businesses benefited from strong demand and raised product prices after the wartime wage-price controls were lifted. The inflation was temporary but intense, with three consecutive years of inflation exceeding 10 percent after the removal of wartime price controls.
The Fed belatedly tightened monetary policy through higher bank capital requirements and reserve requirements, while the government’s defense spending fell faster than anticipated and fiscal policy turned restrictive. This generated a mild recession in 1949 that quickly subdued inflation. This episode highlighted two common themes. First, monetary stimulus generates aggregate demand with a lag. Second, once inflation rises significantly, it is difficult to reduce it without harming economic expansion.
The late 1960s. After a decade of subdued inflation leading up to 1965, inflation accelerated significantly 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 programs and Vietnam War spending—accommodated by easy monetary policy generated excess demand and higher inflation. By the 1960s, activist Keynesian policy prescriptions had become mainstream. Lowering unemployment took precedence and the belief that moderate inflation was good for economic performance dominated policy makers’ mindset.
Although the ramping up of government spending stimulated demand, to the dismay of fiscally conservative Fed chair William McChesney Martin, the Fed caved in to LBJ’s wishes not to raise interest rates in late 1965. The Fed attempted to dampen aggregate demand in the summer of 1966 through higher bank capital requirements and not lifting Regulation Q on interest rates. This resulted in a “credit crunch” that temporarily stalled economic activity, forcing the Fed to step back. Accelerating Vietnam War spending and renewed monetary accommodation spurred aggregate demand and rising inflation. The Martin-led Fed began raising rates aggressively only after LBJ announced he would not seek re-election. Coupled with the extension of the Vietnam War surtax, the economy tilted into mild recession in 1970.
The 1970s. After the recession of 1970, inflation receded only to 3.5 percent, more than double its 1965 average, and inflationary expectations remained elevated. New Fed chairman Arthur Burns placed more concern on the high unemployment rate, which rose from 4.2 percent when he became chair in February 1970 to 6.1 percent in December. Reflecting his eclectic views and skepticism of monetary policy, Burns attributed inflation to an array of non-monetary sources, including labor unions and greedy businesses, rather than to Fed policy. This led to his disastrous advocacy of President Nixon’s wage and price controls and abandonment of the gold standard.
Among the many lessons from the misguided policies and high inflation of the 1970s is that the wage and price controls were destructive in many ways, attempting to address the symptoms of inflation rather than its causes, understating the role of inflationary monetary policy, and creating massive confusion. The abandoning of the gold standard in August 1971 unanchored inflationary expectations. The Fed’s accommodative monetary policy during Nixon’s re-election bid fueled inflation pressures that were constrained by wage and price controls. High inflationary expectations then became embedded in wage- and price-setting behavior, pushed up interest rates, and damaged financial markets.
The oil price shocks in November 1973 and in 1979 contributed to inflation and poor economic performance, but in the absence of accommodative monetary policy these negative supply shocks would not have generated sustained excess demand and inflation. After a temporary spike in nominal spending, aggregate demand and inflation would have fallen. Instead, nominal GDP growth exceeded 10 percent in the consecutive years 1978–81, creating the excess demand that fueled the wage-price spiral.
In the end, the 1970s saw a decadelong policy tilt toward prioritizing lower unemployment while using failed administrative means to keep a lid on inflation without any viable strategy for lowering that inflation. These actions eroded the confidence of the public and the financial markets and culminated in the US dollar crisis in 1978. The appropriate and necessary disinflationary policies of the Volcker-led Fed broke inflation, and inflationary expectations resulted in damaging recessions during 1980–82 but ushered in a sustained period of moderate inflation and healthy economic performance.
The 1990s. Fed policy during the 1990s was highlighted by one of the Fed’s greatest successes: a mid-cycle monetary tightening in 1994 that resulted in an economic soft landing and in reduced inflationary expectations that established the basis for strong economic performance in the second half of the decade.
The Fed had sustained monetary accommodation during the so-called “jobless recovery” that followed the shallow recession of 1990. In delayed response to the economic overheating that began in 1993, the Fed raised rates sharply, from 3 percent in February 1994 to 6 percent a year later.
This dampened inflationary expectations and successfully orchestrated an economic soft landing, but the sharp rate increases were not costless. Domestically, spikes in Treasury and mortgage yields resulted in bankruptcies of several US public sector money managers. More important, the Fed rate hikes contributed to the Mexican debt and peso devaluation crisis (the “tequila crisis”) that rippled through Latin America.
The 2000s. The negative side-effects of rate hikes in 1994 heavily influenced the Greenspan-led Fed. In 1999, the Fed maintained monetary accommodation despite an overheating economy and the dot-com stock market bubble because it mistakenly insisted on maintaining excess liquidity going into 2000. Then it tightened monetary policy too much. The stock market bubble burst, and recession unfolded in 2001, culminating with the shock of the 9/11 terrorist attacks. After 9/11, a new worry surfaced at the Fed: inflation fell to 1 percent and the Fed feared that the United States would follow Japan’s 1990s path of deflation, which would lead into a downward spiral of weak aggregate demand from which escape would be difficult. Fed chairman Greenspan characterized deflation as a low-probability but high-cost outcome, and tilted monetary policy decidedly in the other direction, while Fed governor Bernanke described how Fed asset purchases could combat deflation if the Fed faced the zero lower bound.
Even as inflation rose to 2 percent, the Fed kept rates at 1 percent, and when it belatedly began raising rates, in deference to the jarring impacts of the rapid rate increases of the mid-1990s, the Fed gave advance warning of very gradual increases, with a clear objective of minimizing any disturbance to financial markets. For a sustained period, rates were well below what a Taylor-type monetary policy rule would have prescribed and real estate activity and values and mortgage debt soared.
While the Fed’s policies did not cause the debt-financed housing bubble, which was characterized by a proliferation of excessively complex mortgage-based debt instruments, the Fed’s lower-for-longer monetary policy clearly facilitated the debt-financed housing boom. Subsequent rate increases in 2005–6 shifted expectations about housing and unraveled the mortgage debt markets. This led to the financial crisis. This was another instance in which the Fed’s delayed exit from monetary ease proved costly.
After the Great Financial Crisis (GFC). The Fed’s sustained aggressive monetary ease was striking in character and impact, with considerable longer-run ramifications. The Fed followed its QE1 crisis response in November 2008 with QE2, “Operation Twist” (selling short-dated securities and buying long-dated securities), and open-ended QE3. Fed chair Bernanke stated that the primary purpose of QE3 was to lower the unemployment rate. The Fed subsequently maintained zero interest rates until December 2015, well after the economy had recovered on a self-sustaining basis. While the economy grew slowly and labor markets improved gradually after the Great Financial Crisis, inflation remained subdued and stayed below the Fed’s 2 percent longer-run target. The Fed raised rates very gradually from December 2015 to September 2018, to 2.5 percent, modestly higher than inflation. Although this jarred financial markets, the economy continued to expand and the Fed avoided recession. The elongated modest expansion following the financial crisis heavily influenced the Fed’s policy making in response to the 2020 pandemic.
The Fed learned the wrong lessons from this episode. Inflation stayed low because the Fed’s unprecedented monetary ease beginning in 2009 did not stimulate an acceleration in aggregate demand, with nominal GDP never accelerating above 4 percent, providing little support for higher prices or wages. The economic and financial environment was negative, with a crippled banking system and housing sector, and fragile household finances took years to repair. The American Recovery and Reinvestment Act of 2009 provided only limited stimulus, and tax increases in January 2013 imposed fiscal restrictiveness.
In this environment, the Fed’s quantitative easing increased bank reserves and the monetary base, but remained as excess reserves, and did not translate into increased money supply or credit expansion that generated economic activity. This may be attributable to the Fed paying interest on excess reserves beginning in October 2008, raising capital and liquidity requirements, and imposing tighter controls and bank supervision as part of its stress tests of the large banks. The Fed’s strategic review in 2018–19, which focused on the low inflation and worries about the effective zero lower bound, did not thoroughly analyze why monetary policy failed to achieve the Fed’s 2 percent inflation target.
The 2020 pandemic and today. In response to the unfolding severe economic contraction and dysfunction in the US Treasury market, the Fed reduced rates to zero and engaged in massive asset purchases, including mortgage-backed securities. The Fed’s actions were matched by the largest fiscal support package in US history. Financial markets quickly stabilized and in May 2020 there were signs that the economy was beginning to recover. The government followed with more and more stimulus, which totaled over $5 trillion in deficit spending, over 25 percent of GDP. For nearly two years, the Fed has maintained its zero rates and its asset purchases have more than doubled its balance sheet to $8.9 trillion.
The Fed made clear that a critical lesson it had learned from the Great Financial Crisis was that its monetary response had been too timid, and it presumed that the subdued inflation that followed the GFC would be repeated. This presumption emboldened the Fed to aggressively pursue its maximum employment mandate. The Fed’s new strategic framework that chair Powell introduced in August 2020 institutionalized the Fed’s unbalanced approach to monetary policy, prioritizing maximum employment and explicitly favoring higher inflation. The Fed interpreted its assessment that the Phillips Curve was flat as eliminating the need to pre-emptively tighten monetary policy in response to conditions of maximum employment.
The Fed’s presumptions and forecasts proved wrong. The economy and labor market recoveries far exceeded Fed expectations and inflation rose far above its December 2020 forecast of 1.8 percent in 2021. Even as the recovery accelerated, the Fed emphasized the downside economic risks and asserted that the high inflation was transitory. It incorrectly attributed the inflation to supply shortages, while largely ignoring robust aggregate demand and understating the impact of its aggressive monetary stimulus. The Fed subsequently backed off this assertion.
Consumer Price Index inflation had risen to 6.9 percent and personal consumption expenditure inflation to 5.7 percent before the Fed signaled in December 2021 that it would need to raise rates in 2022. By then, the Fed’s delayed exit had put monetary policy way behind the curve.
Certainly, the pandemic has posed unique risks for the Fed. But its current situation is nothing new. Rather, it is an unfortunate repeat of a history of delayed exits from extended monetary ease.