On the Fed’s recent monetary policy.
The collapse of Silicon Valley Bank, according to Wall Street observers, will force the Federal Reserve to pause its policy of raising short-term interest rates to slow rising prices across the economy. Following that logic, the Fed will decide that it is better to accept the risk of rising prices than to cause a banking crisis by continuing to raise rates.
That makes sense—except that it probably means that prices will start rising again as the Fed eases rates and provides liquidity to troubled banks. It also means that we may return to the “stop and go” policies of the 1970s that perpetuated inflation through the entire decade.
Prices surged in 2021 by 7 percent and in 2022 by 6.5 percent, the largest annual increases in inflation since the early 1980s. The most recent figures for February suggest that year-over-year inflation remains at around 6 percent, with food and housing prices rising by nearly 10 percent over the past twelve months. Real interest rates remain in negative territory, with price increases of 6 percent per year exceeding interest rates currently between 4 and 5 percent—also an inflationary condition.
Many have said over the past year that inflation was caused by factors other than monetary policy, for example: disruptions in supply chain, the Russia–Ukraine war, and spikes in oil prices. Chairman Jerome Powell seemed to accept these explanations a year ago, but he has recently discarded them because it is now clear why prices spiked over the past year.
First, the Federal Reserve increased the money supply (using M2 as the broad measure of money, which includes cash, checking deposits, etc.) by 28 percent from 2020 to 2021 in response to the coronavirus pandemic and by another 11 percent from 2021 to 2022 in continuation of that policy. All told, the Fed increased the money supply by 24 percent over the two-year period, while the economy advanced in real terms by just 4 percent over the same period. That kind of monetary stimulus has never before been attempted.
Second, in dealing with the pandemic, the federal government spent and borrowed heavily during these two years, with total debt increasing from $22.7 trillion at the beginning of 2020 to $26.9 trillion by the end of the year—an increase of almost 20 percent. The Biden administration, pouring gasoline on the blazing fire, added another $3.7 trillion to the debt in 2021 and 2022, an increase of another 13 percent, even as the pandemic was receding. Federal Reserve banks purchased nearly $4 trillion of that debt, thereby adding reserves that member banks could use to finance loans.
That triple burst in money supply, federal spending, and bank reserves caused the rising inflation that hit the economy in 2021 and 2022. The Federal Reserve has managed to slow inflation somewhat over the past year by raising the federal funds rate (the rate at which commercial banks make overnight loans to one another) from 0.08 percent in March 2022 to 4.6 percent in February of this year, accompanied by modest reductions in the money supply. In addition to subduing inflation, that policy has also caused trouble for some banks, which may persuade governors of the system to reconsider their interest-rate policy.
What happens if inflation surges again? That is a good question, and one that takes us back to the 1970s.
During that period, inflation surged from around 2 percent per year in the late 1960s to 5 percent by 1971, at which point President Nixon imposed wage and price controls to support the value of the U.S. dollar. Prices surged again in 1973 when those controls were removed, with increases reaching 10 percent in 1974 and 13 percent in 1980, with some price increases (home mortgages) far exceeding those levels. Throughout that period the Federal Reserve adopted a series of “stop and go” policies of raising and reducing rates in response to immediate developments and in the hope that added doses of harsh medicine would not be needed. Many in positions of influence claimed (as now) that rising prices were due to factors other than monetary policy—surges in oil prices, for example, or wage increases negotiated by labor unions or excessive government spending, or all of the above.
As a result, the Fed never adopted consistent policies to address inflation, which as time passed encouraged an inflationary psychology to take hold under which prices and wages increased because people expected them to increase. That left the Fed “behind the curve,” as the saying goes, chasing inflation with half-hearted and inadequate measures, as prices surged through the decade with no obvious end in sight. The longer the Fed waited to address inflation, the harsher the medicine it would have to apply to bring it under control.
That eventually happened in late 1979 when Paul Volcker, the new chairman of the Federal Reserve, decided to apply that medicine once and for all, raising the federal funds rate to 17 percent in early 1980 and to 19 percent in January 1981, just as Ronald Reagan came into office. Those rates were unheard of before that time, and reminded many of “banana republic” conditions. The rates did cause a recession beginning later that year (as many feared), with unemployment increasing to more than 10 percent the following year—but those policies did succeed in bringing inflation down.
Unfortunately, relief did not come immediately: it took two years, from 1980 to 1982, for the new rates to bring inflation down into single digits. By 1983, year-over-year inflation was down to 3 percent, setting the stage for a robust recovery and stock-market boom that continues to this day. Over the nearly four decades from 1983 to 2022, inflation never exceeded 4 percent per year (apart from 6 percent in 1990), thanks mostly to the difficult decision Volcker made when he came into office—and also to President Reagan’s decision to support his policies through some difficult times.
Are we headed for the same place today—with the Fed adopting “stop and go” policies because rising rates, in addition to containing inflation, also cause a host of other problems, from bank failures to recession and unemployment? That may be so. Nevertheless, as we learned in the 1970s, the longer the Fed waits to tackle inflation, the more difficult its task will be.
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