In 108 Years the Fed is Zero-for-Eight Stopping 5%+ Inflation Without Recession

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“Throughout its 108-year history the Federal Reserve has never succeeded at reversing an inflation rate of 5% or greater without producing a recession. At zero for eight, its batting average is literally zero.”

-Cautious Optimism Economics Correspondent

4 MIN READ - A dispatch from the research department of the Cautious Optimism Correspondent for Economic Affairs and Other Egghead Stuff.

In recent weeks the Economics Correspondent has commented he believes a recession is extremely likely if the Federal Reserve uses the higher policy interest rates and/or quantitative tightening needed to bring inflation down to its target rate of around 2%.

Even if the United States enters a technical recession soon due to the possibility of a slightly negative consecutive second quarter, the Correspondent fears the shallow contraction will deepen later as the effects of future rate hikes have yet to be felt.

The Correspondent believes this in part due to economic theory. Most of the major macroeconomic schools—the Keynesians, the Monetarists, the Austrians, and the Modern Monetary Theorists—agree that a rapid increase in interest rates triggers an economic retrenchment, although they disagree on the specific mechanism that the higher rates trigger to induce the slump.

However what the Economics Correspondent finds more convincing than theory, and believes most of the public also finds more persuasive, is empirical evidence. 

So the Cautious Optimism Economics Correspondent’s research department, composed of himself and his computer, offers this exclusive, high-powered analysis:

Beware. Throughout its 108-year history the Federal Reserve has never succeeded at reversing an inflation rate of 5% or greater without producing a recession. At zero for eight, its batting average is literally zero.

Where's the empirical evidence you ask? See the St. Louis Fed’s own CPI chart (attached) and read further for more details on what appears to be an exception in 1951—but isn’t.

To access the chart directly go to the St. Louis Fed at:

https://fred.stlouisfed.org/graph/?g=Qpsy

And to view the relationship between the Fed Funds policy rate (rising as the Fed tries to slow down the inflation that it itself has created) and subsequent recessions, view:

https://fred.stlouisfed.org/series/FEDFUNDS

Perhaps in 2022 by divine intervention the Fed might bring inflation down from today's official 8.6% CPI to around 2% without a recession, but if it actually succeeded it would be through a combination of blind luck and a miracle.

So the Economics Correspondent would definitely not take that bet.

And up until yesterday the Jay Powell Fed has tried repeatedly to promote a “glass half full” outlook, citing the Fed’s success in raising interest rates in 1994 without causing a recession: a textbook example of the so-called “soft landing.”

However just a glance at the CPI chart reveals the inflation rate in 1994 was nowhere close to 5%. Rather, it sat near 2.5% for the entire year.

If the inflation rate in 1994 had been 8.6% instead of 2.5%, the Economics Correspondent is confident the more aggressive rate hikes needed to bring it down would have also made the soft-landing scenario all but impossible.

Powell seems to be coming around to the reality. Yesterday in Congressional testimony he admitted that a soft-landing “is going to be very challenging.”

That concludes the main post, but read on for a few more wonkish details about 1951 and the pre-1948 period.

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Postscript:

1) There appears to be an exception in 1951, where inflation peaks at 9.6% before falling rapidly without a recession.

The Economics Correspondent has analyzed quarterly GDP data for 1950 and 1951 at the Bureau of Economic Analysis, and in fact the private sector did go into recession.

However massive government spending on the Korean War helped the country avoid an official recession, but only mathematically.

The definition of GDP is private consumer spending + private business investment spending + government purchases + net exports, or famously: C + I + G + Nx = Y.

Adding just the private sector components—C, I, and Nx—there were two consecutive quarters of economic contraction in late 1950 and early 1951, and contraction in three out of four quarters.

But a sharp uptick in government war spending mathematically offset the contraction enough for overall GDP to contract in only one quarter.

However there’s no question that the private sector, what really matters, fell into recession.

2) The St. Louis Federal Reserve chart doesn’t include the 1914-1948 period.

However historical inflation records reveal that shortly after the establishment of the Federal Reserve inflation exceeded 5.0% for nearly five years (March 1916 to December 1920). 

Economic historians also record that the Benjamin Strong New York Fed famously pushed real interest rates up to 24% (8% nominal plus a 16% trough deflation) to stop the inflation, producing the Depression of 1920-21 along the way.

There were no more major inflation episodes in the 1920’s and the country entered a major deflation in the early 1930’s as over 9,000 U.S. banks failed in the opening years of the Great Depression. 

Inflation briefly eclipsed 5% for a few months in 1934 but the entire 1930’s decade is already considered one long depression.

3) To finance massive World War II expenditures the Fed resorted to aggressive money creation, but wartime price controls concealed the effect other than shortages.

In the immediate postwar period price controls were lifted, triggering a major acceleration in price inflation as the effects of years of new money were at last felt. The inflation rate persisted between 8.5% and 19.7% for twenty months ending in January of 1948.

Returning to the attached CPI chart, we can see the Fed’s reaction in early 1948: a major interest rate hike that kneecapped the inflation, but not without producing another recession in 1948-1949.