The U.S. economy seems headed for a recession later this year or early next year. A recession would make clear that the new monetary policy strategy the Federal Reserve announced in August 2020 has been a failure.
The Fed’s new strategy represented a break with the approach it had adopted in response to The Great Inflation of 1968-1982, when inflation eventually soared above 10 percent. Although oil price shocks contributed to the Great Inflation, most economists believe that Fed policy failures were the reason the inflation was so severe.
Arthur Burns, who was Fed Chair from 1970 to 1978, thought inflation was mainly the result of structural factors such as the power of unions or the pricing power of large firms. Accordingly, Burns was reluctant to raise interest rates, believing that doing so hurt the housing industry without reducing inflation. He advocated wage and price controls instead.
Paul Volcker, appointed Fed chair by Jimmy Carter in 1979, showed that monetary policy could, in fact, deal with inflation. By raising the target for the federal funds rate to 22 percent, Volcker brought the inflation rate from above 11 percent to below 4 percent — but only at the cost of the severe recession of 1981-1982.
Volcker’s shock therapy was needed because as inflation had increased, workers, firms and investors ratcheted up their expectations of future inflation. As that happened, those higher inflation rates became embedded in the economy in wage increases, raw material contracts and interest rates. That process could only be reversed if the Fed could convincingly demonstrate that it would keep monetary policy tight long enough to bring inflation down.
The Great Inflation taught the Fed that monetary policy should preempt increases in inflation before they became embedded in the economy. Changes in monetary policy can take a year to have their full effect, so the Fed needed to begin raising interest rates when the unemployment rate dropped below the so-called natural rate of unemployment, even if inflation had not yet begun to accelerate. The Fed was still following this approach in 2015, when it raised its target for the federal funds rate even though its preferred measure of inflation was still below its 2 percent target.
By July 2019, a majority on the Fed’s Federal Open Market Committee had come to believe that with no sign of inflation accelerating, they could safely cut the federal funds rate. But they had not yet explicitly abandoned the view that their job was to preempt increases in inflation. The formal change came in August 2020 when they announced that they were adopting a flexible average inflation target (FAIT). Rather than viewing 2 percent as effectively a ceiling on inflation, they now would allow inflation to rise above 2 percent provided that it averaged 2 percent over an unspecified period. They also would no longer focus mainly on the unemployment rate in assessing the state of the labor market.
There are two key problems with the Fed’s new monetary policy strategy. First, it’s unclear by how much inflation can exceed the 2 percent target or for how long it needs to stay there before the Fed will react. Second, by waiting until it has exceeded the 2 percent target, the Fed has abandoned the decades-long policy of preempting inflation.
We’ve seen the results of the new strategy over the past year. Inflation has been above 2 percent since March 2021, but only now has the FOMC raised its target for the federal funds rate to 0.25 percent. The FOMC’s long-run target is 2.5 percent, so with 0.25 percent increases at each meeting, it won’t reach 2.5 percent until April 2023.
Even then, the real federal funds rate will be negative. During the 1970s, inflation accelerated under Burns when the real federal funds rate was negative and only declined when Volcker’s increases in the target resulted in a positive real federal funds rate.
It seems unlikely that inflation can be brought down to 2 percent until the real federal funds rate becomes positive. Some FOMC members agree. James Bullard, president of the St. Louis Fed has argued for raising the target to above 3 percent this year. While rapid increases in interest rates should succeed in reining in inflation, they are also likely to cause a recession. As Atlanta Fed President Raphael Bostic has noted, in every similar case since 1960, when the Fed has had to respond to a rapid increase in inflation, the result has been a recession.
The new monetary policy strategy the Fed adopted in August 2020 has left it without good options. It can follow the present course of slowly increasing interest rates, which will allow high inflation to persist for at least the next two years, or it can increase rates more rapidly, which will bring down inflation, but likely push the economy into a recession.
Anthony O’Brien is a professor of economics, emeritus at Lehigh University.