Featured Publication

“The Fed Replays History,”

by Michael D. Bordo and Mickey D. Levy

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.

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