Historical patterns have shown us that the challenge of curbing high inflation without plunging into a significant recession is indeed a colossal task. There is a longstanding belief among economists that to genuinely counteract strong inflationary forces, a deep recession, unfortunately, becomes a necessary evil. To make matters worse, this perspective goes a step further. Specifically, any delay in taking drastic measures to curb economic growth to fight high inflation could destabilize inflation expectations and make a difficult situation that much worse.
When discussing this historical perspective, the inflationary episode in the U.S. during the late 1970s and early 1980s often stands out. These were harrowing years for the U.S. Federal Reserve. At this time, the U.S. experienced a period of high inflation, commonly referred to as "stagflation", because it was accompanied by stagnant economic growth. To combat this high inflation, the Federal Reserve took dramatic measures to tighten monetary policy. At that time, the chairman of the Fed was Paul Volcker. He was confirmed by the United States Senate and started his first of two terms as Fed chairman in 1979. His name to this day goes down in history as the architect of a program that defeated painfully high inflation albeit at the cost of a sharp early 1980s economic recession.
The Fed's Monetary Policy Response in the Late 1970s and Early 1980s
To accomplish the feat of lowering severe inflation and reigniting growth, the Fed did a few things.
Significant Interest Rate Increases: The most notable action was a substantial increase in the Federal Funds Rate. Under Volcker's leadership, the Fed raised the rate multiple times, with the rate peaking at about 20% in June 1981. These were some of the highest rates in U.S. history.
Shift to Money Supply Targeting: Prior to Volcker, the Federal Reserve primarily focused on targeting interest rates. Volcker shifted the focus to targeting the money supply, particularly the M1 money supply (which includes currency in circulation and checkable deposits). This was a significant departure from previous policy.
Persistent Tightening: Despite facing significant political pressure and criticism, as well as a recession in the early 1980s, the Federal Reserve under Volcker remained committed to its tight monetary stance until inflation was brought under control.
The results of these policies were initially painful. The U.S. economy was battered by a sharp recession in the early 1980s. However, by the mid-1980s, inflation rates had fallen dramatically and the U.S. entered a period of sustained economic growth. The Volcker-led policies are often credited with breaking the back of the high inflation of the 1970s and setting the stage for the economic expansion of the 1980s and 1990s. Figure 1 shows the U.S. core inflation rate year over year change. Note the ugly spike topping out at just above 13% in the first half of 1980. Further consider that inflation rates have never been back to anything like they were in the late 1970s and early 1980s. Yes, core inflation did top out at around 6.5% in recent times, but the historical perspective makes these recent figures a bit easier to digest. Nonetheless, that trough of lower and lower core inflation rates through the 1990s and up until the Covid pandemic took a recession to generate. Fair trade in the long run?
FIGURE 1 - A graph of historical U.S. economy core inflation YoY data. Note the peak in early 1980.
Traditional Monetary Policy
So goes the "traditionalist view" as the current president of the Federal Reserve Bank of Chicago, Austan Goolsbee, has named it. Traditionalists often focus mainly on current economic growth and labor market trends when predicting the trajectory of inflation. They believe the only way to correct high inflation is an engineered economic recession with its requisite high unemployment and downward pressure on wages. However, Mr. Goolsbee argues that placing excessive faith in the link between high inflation and unemployment can be a miscalculation. If central bankers blindly follow the traditional path of seeking higher unemployment as the solution for sticky inflation, the U.S. economy may suffer an unnecessary recession.
The U.S. Federal Reserve's typical policy response to high inflation is to tighten monetary policy. This often involves raising the federal funds rate, selling government securities, increasing the reserve requirement, and a public relations campaign to promote and signal these actions while at the same time demonstrating resolve to control inflation.
Raising the Federal Funds Rate: This is the interest rate at which banks lend to each other overnight. A higher rate can make borrowing more expensive, potentially slowing down consumer spending and business investments, which can help cool an overheated economy and reduce inflationary pressures.
Selling government securities: By selling government bonds, the Federal Reserve can absorb excess money from the banking system, thereby reducing the supply of money and putting upward pressure on interest rates.
Increasing the reserve requirement: This is the amount of funds banks are required to hold in reserve and not lend out. By increasing this requirement, the Fed can reduce the amount of money banks can lend, which can slow down the expansion of the money supply.
Rhetoric and communication: The Federal Reserve can also use its communication channels to signal its intentions to the market. If market participants believe the Fed is serious about fighting inflation, they may adjust their behavior accordingly, even before actual policy actions are implemented.
The traditionalist viewpoint is currently echoed by current Fed chairman, Jerome Powell. Only just last week, Chairman Powell indicated in a prepared speech that inflation remains elevated and might necessitate a slowdown in economic growth. He also mentioned that the present monetary conditions are not excessively stringent. Nevertheless, the markets anticipate that the central bank will maintain interest rates unchanged in the November gathering. And so the markets continued to fret this past week about not necessarily a threat of rising interest rates but of “higher for longer” interest rates.
The New Perspective on Monetary Policy
The reason a traditional approach to monetary policy may be incorrect at this moment in time is painfully obvious. Think about it: what major, unanticipated world-wide event preceded this terrible bout of high inflation? A pandemic. It is a rational idea that the primary drivers of post 2020 inflation stemmed from the impact of the Covid-19 Pandemic. This unique event led to widely recognized disruptions in the supply chain as well as unexpected changes in what consumers wanted and bought. Compounding these challenges on the supply side, the pandemic also resulted in fewer people working. Notably, many women and individuals approaching the age of retirement opted out of the workforce. Additionally, there was a significant decline in people moving to the United States, further constraining available labor. This combination of factors significantly strained both supply chains and the labor market, and the result was high inflation.
If that explanation for inflation is true, central bankers must now be willing to exercise restraint with monetary policy rather than overshoot their response and trigger an otherwise avoidable recession. Blind allegiance to the policy measures that worked in the past is wrong. Yet even if central bankers recognize the unique circumstances put into play by a global pandemic, reacting to them is a challenge all its own. There is no playbook for how to navigate the economic disruptions left in the wake of global medical shock. At risk is nothing less than the next decade of economic prosperity for the U.S. economy. The 1980s were a defining moment for the U.S. Federal Reserve; the actions taken to return to economic prosperity are still studied to this day. Now the Fed has another chance to make history. If central bankers can steer the economy through these rough times, future economists will study our current time for decades to come.
Yorumlar