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.
- Is the Federal Reserve responsible for the inflation after the pandemic? Why or why not?
- How would you prevent inflation from occurring?
Inflation is at a forty-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 the Fed’s history of waiting too long to tighten monetary policy when inflation rises.
After World War II, the Fed maintained low interest rates and easy money even though prices were quickly rising. The Fed only tightened monetary policy after three years of double-digit inflation. Inflation fell, but the Fed’s action led to recession in 1949.
In the 1960s, large spending increase by the federal government were accommodated by easy monetary policy. 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 this recession, inflation remained high and inflationary expectations were elevated. Policymakers blamed labor unions and greedy businesses and pushed for wage and price controls rather than tighter monetary policy. The result was a decade of high inflation rates that only ended when Paul Volker became Fed chairman and he 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. 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 acknowledge 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 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.