The Fed Replays History: Lessons in Dealing with Inflation
Published January 11, 2023
Historically, the Federal Reserve has contributed to periods of high inflation—followed by painful recessions—by responding sluggishly to economic signals. The Fed appeared to have learned its lesson after the recession of 1980–82, which was followed by 40 years of relatively low inflation. But after the pandemic of 2020, the Fed was slow to respond to mounting inflation. Adherence to a rules-based approach would discourage such mistakes in the future.
Discussion Questions:
- Is the Federal Reserve responsible for the inflation after the pandemic? Why or why not?
- How would you prevent inflation from occurring?
Additional Resources:
Inflation is at a 40 year high, and the Federal Reserve is now trying to tighten monetary policy to reduce inflation while avoiding a recession. This is an unfortunate repeat of a costly pattern. The Fed has a history of waiting too long to tighten monetary policy when inflation rises, often because of political consequences or pressure.
After World War II, the Fed maintained low interest rates and easy money, even though prices were quickly rising. This led to three years of double digit inflation before the Fed finally tightened monetary policy. Inflation fell, but the Fed's action led to recession in 1949. In the 1960s, the Fed's easy monetary policy enabled large spending increases by the federal government.
Just like after World War II, these policies led to inflation and again the Fed was slow to respond. When it finally did, its actions pushed the economy into another recession in 1970. After that recession ended, the Fed was slow to tighten again because it was afraid of unemployment, employment rising and starting another recession.
The result was a decade of high inflation rates. That only ended when Paul Volcker became Fed chairman and tightened monetary policy. Like the prior periods, though, breaking inflation led to damaging recessions from 1980 to 1982. After 1982, the Fed seemed to finally learn its lesson, opting to raise rates and tighten monetary policy sooner rather than later.
A 40 year sustained period of moderate inflation and healthy economic performance followed. But then Covid-19 happened. At the beginning of the pandemic, the Fed loosened the money supply. By 2021, the economy was recovering and inflation was rising but the Fed didn't move. It maintained that the inflation was due to temporary supply shortages.
It took several more months before the Fed acknowledged that the inflation wasn't transitory and tighter monetary policy was needed. How can we ensure that the Fed doesn't forget the lessons of history again. The answer is to replace replace the Fed's discretionary policies with a rule based approach where inflation is quickly followed by tighter monetary policy, regardless of the short term political consequences.