Figure 2 illustrates the very different policy responses to recessions and high inflation of the Burns- and Volcker-led Federal Reserve, as these outcomes have implications for the centrsal bank’s likely course of action in the next recession. Under Burns, even as inflation began to rise above four percent in late 1973, the policy rate was kept above the rate of inflation only during the first half of the recession. Not surprisingly given this accommodative policy stance, core inflation continued to rise throughout the recession, and eventually stabilized mid-decade at a very high level, above six percent, before rising further during the second oil shock.
In the Volcker era, by contrast, the Fed cut the policy rate below the inflation rate during the 1980 recession but increased the policy rate sharply above the inflation rate once again when the economy showed signs of stabilizing, as the right side of Figure 2 shows. Focused on beating inflation, the Volcker-led Fed kept policy restrictive and induced a second recession in 1981. And policy remained tight, with the policy rate staying above the rate of core inflation throughout the subsequent recovery.
The economic outcomes of these two policy responses differed sharply, even apart from inflation. Figure 3 shows that the unemployment rate remained above its estimated natural level for the majority of Volcker’s term as Federal Reserve Chairman. While Volcker’s war on inflation inflicted pain on many households through a persistently weak labor market, it is widely credited with laying the groundwork for the Great Moderation, the 20-year period of low inflation and decreased economic volatility that started in the mid-1980s.
What can we expect from the Powell-led Fed, when the next recession occurs? If the recession begins early next year, with core PCE inflation still above 4%2, I think Powell is much more likely to maintain a “Volcker-esque” focus on bringing down inflation than, like Burns, to switch his focus to supporting the economy and labor market. A key lesson that today’s policymakers take from the Great Inflation is that delaying action to bring inflation down to a more tolerable level leads to worse economic outcomes down the road; price stability is necessary to keep the economy close to maximum employment over the long term. As the saying goes, only hawks go to central bank heaven.3 And judging by his own comments, Powell wants to join Volcker there.4
The fundamental difference between the current environment and the early 1980s is that, with inflation lower, long-term inflation expectations remain well-anchored. This suggests that, despite its forecasting errors and slow response to inflation pressures, and criticism from pundits to the contrary, the Fed’s inflation-fighting credibility remains intact. This should give the Powell Fed some flexibility to respond to weaker growth, even with high inflation, but not the full flexibility to cut rates close to zero and maintain an easy policy stance for long. Significantly shifting its focus from inflation-fighting to restoring growth would risk a mid-1970s outcome, with rising inflation expectations and inflation remaining high. If Powell has fully absorbed the lessons of the Great Inflation, limited monetary policy support is likely in the next recession, and thus the recovery is much more likely to be sluggish than robust.
Figure 2: INFLATION AND THE POLICY RATE UNDER BURNS AND VOLCKER
Figure 3: LABOR MARKET CONDITI ONS UNDER BURNS AND VOLCKER
UNEMPLOYMENT RATE LESS NATURAL RATE OF UNEMPLOYMENT
1. In addition, as balance sheet run-off is highly unlikely to be completed before the next recession, there may be less appetite on the FOMC to fully redeploy another round of quantitative easing.
2. The FOMC’s June economic projections indicate that the 18 Committee participants expect core PCE inflation to end 2022 anywhere from 4.1 to 5.0 percent.
3. This saying paraphrases Bob McTeer, who used variations of it in many speeches during his tenure as President of the Federal Reserve Bank of Dallas from 1981 to 1991.
4. See, for example, Powell’s discussion in his post-meeting press briefing on May 4 of Volcker’s legacy and lessons for policy today.
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