This Memo is extracted from Michael Bordo’s address at the C.D. Howe Institute’s annual David Laidler lecture last month.
To: Monetary Policy Observers
From: Michael Bordo
Date: October 31, 2022
Re: History Unlearned Dogs the Federal Reserve’s Inflation Fight
Many of the monetary policy issues long thought resolved are back with a vengeance in 2022.
And when one studies the history of economic cycles since the First World War, and the responses of the US Federal Reserve, the parallels today with the Great Inflation of the sixties and seventies are unmistakable.
Then, Vietnam and Great Society social spending combined with accommodative monetary policy to drive inflation.
This time, COVID-19 was the catalyst for similarly unprecedented levels of government spending and monetary expansion.
The Fed was too slow to raise rates in the second half of the 1960s, bowing to pressure from President Lyndon Johnson. Inflation rose and set the stage for the disastrous 1970s. In that decade, along with two pronounced oil price shocks, Fed chairman Arthur Burns favored the imposition of wage and price controls rather than monetary restraint and was reticent about raising rates sufficiently to reduce inflation because he feared rising unemployment. It took the shock of a US dollar crisis and double-digit inflation which led to the painful aggressive anti-inflation policies of Fed chairman Paul Volcker – and Gerald Bouey in Canada – to restore order.
In the current episode, as the economy rebounded sharply from the pandemic, fueled by aggressive monetary and fiscal stimulus, the Fed and other central banks saw post-Covid supply issues as temporary and delayed their exit from loosened monetary policy too late to forestall our current inflation surge. They collectively thought they must tighten monetary policy just enough to reduce inflation but not so much as to generate a recession.
This reflects the Federal Reserve’s behind the curve behaviour since its founding, as I argued with Mickey Levy recently, marked by delayed exits from extended monetary easing.
There have been three soft landings since 1985 when the Fed moved in a timely fashion, but its mistakes have involved costly errors. Fearing a Japanese-style deflation in the early-2000, the Fed’s too-low-too-long interest rate policy fueled the debt-financed housing bubble that generated financial instability and culminated in the Great Financial Crisis of 2008-09.
While countercyclical monetary policy is a difficult task, the Fed does not seem to take the appropriate lessons from history.
The 2020 pandemic posed a negative shock to aggregate supply and aggregate demand. Pent up demand and unprecedented fiscal stimulus and sustained aggressive monetary ease fueled a V-shaped recovery involving strong demand amid ongoing supply constraints. The Fed’s maintenance of zero rates and continuation of massive asset purchases long after these emergency policies were necessary have resulted in the highest inflation since the 1960s and 1970s.
Focusing on cycles since the Second World War, one finds a persistent pattern of the Fed extending its monetary policy easing too long and delaying its tightening exits.
The evolving policy anchors and the Fed’s developing objectives – conspicuously, it added employment to its goals – resulted in major policy errors that contributed to the Great Inflation of 1965 to 1982. The current high inflation has some key differences that distinguish it from the 1970s, but the Fed’s extended denial of any similarities between the two periods has allowed some of the more troubling characteristics of the Great Inflation to reemerge and threaten sustained economic growth.
The Fed’s current monetary policy mistakes did not just occur out of the blue. Rather, its new strategic framework and delayed exit from its pandemic emergency policy responses are a culmination of the evolution of its objectives and discretionary policy deliberations. The Fed’s earlier anchor of price stability evolved into a low inflation target and more recently toward favouring higher inflation out of fear that sustained low inflation would risk a collapse in inflationary expectations and a decline of interest rates to the Zero or Effective Lower Bound. This, the Fed perceived, would inhibit its response to an economic downturn. At the same time, the Fed’s long-standing tilt toward prioritizing low unemployment has become more pronounced.
These asymmetries, which have been institutionalized in its 2020 strategic framework – its version of the Bank of Canada’s mandate agreement – have contributed to its current dilemma.
The recent rise in inflation has been predictable, based on the expected excess demand that would be generated by the unprecedented expansive monetary and fiscal policy responses and the nature of the pandemic.
Whether or not the Fed is successful in managing a soft landing, the number of its unforced errors – in which the Fed’s discretion led to poor judgment and costly errors – strongly suggests the need for a policy reset. Were the Fed to adopt more systematic rule-based guidelines – or behave in a more rule-like manner as it did the Great Moderation – it would avoid big mistakes and have a useful framework for conducting monetary policy under abnormal circumstances. Secondly, the Fed needs to correct the flaws of its strategic framework, eliminating its asymmetries and adopting a balanced approach to interpreting and achieving its dual mandate.
Forecasting will always be a challenge, but the Fed should reassess its mistakes and analyze why it has been prone to occasional sizable mistakes. Finally, the Fed must pay attention to history and absorb the appropriate lessons.
Michael D. Bordo is a Board of Governors Professor of Economics and director of the Center for Monetary and Financial History at Rutgers University.
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