Examining One Flawed Reason for the Fed Not to Ease Additionally

October 13, 2010

It is widely recognized that overly stimulative U.S. monetary policy in the 1960s and 1970s was a root cause of the high inflation that developed in the 1970s and 1980s.  Among those opposed to a second round of quantitative easing, a big concern is the fear of replicating that piece of history.  A quote in today’s New York Times from former Fed Governor Robert Heller captures the gist of such concern.

If they start to monetize the federal debt, they will dig themselves a much deeper hole later on.  That’s what we learned from the 1970s, when the Fed undertook a very expansionary monetary policy.  It took a double recession in the early 1980s to wring inflation out of the economy.  We don’t want to repeat that.

Context, as they say, is critically important.  The similarity of the 1970s to present circumstances is the common element of a larger fiscal deficit, but the cause of the red ink is not the same in the two periods.  It was discretionary in the first instance, the product of waging the Vietnam War, launching Great Society programs, and not raising taxes to pay the bill.  The deficit more recently stems primarily from a severe recession that has slashed revenues and lifted social spending.  I submit that the backdrops to that earlier episode and the present one are vastly different.  In a different slice of American economic history, it is also true that an excessively restrictive Fed policy helped transform a recession into the Great Depression, and these times have more in common with that chapter of history than with with the 1970s. 

Compare some key economic trends in the two periods, and one finds much more inflationary danger building in the 1960s and 1970s than in the present.

  • Using the December-over-December rates of unemployment, the jobless rate averaged 4.1% in the 1950s and 4.7% in the 1960s but 5.7% in the 1990s and 5.8% in the 2000s.


  • Real GDP in the United States expanded 4.3% per annum for the twenty years between 4Q49 and 4Q69 but only 2.5% per annum since the end of 1989.


  • The unemployment rate has been 8.9% or higher for the past eighteen reported months.  The last comparable patch of 8.9%-or-higher unemployment occurred in the twenty months from February 1982 to September 1983.  Core CPI inflation in that interval fell from 9.1% at the start to 3.5% at the finish.  When the jobless rate reached 8.9% in March 2009, core inflation was 1.8%, 7.3 percentage points less than in February 1982, and like then, it has dropped sharply, being halved to 0.9% so far.


  • A loose Fed policy in the 1970s gave vent to rapid monetary growth.  M2 expanded slightly faster than 10% per annum in 1976-78, for example.  In contrast, M2 in the week of September 27 was just 2.5% greater than a year earlier.

Before monetary stimulus translates to unacceptably high and accelerating inflation, one will observe brisk growth in money and credit.  Then, real economic growth will expand faster than the potential rate of growth and do so not just in an occasional quarter but over a considerable span of time.  Finally, various measures of price and wage inflation will trend upward, and finally measures of expected inflation will become untethered and follow actual inflation upward.

Seeing none of the above chain reaction thus far, it appears more plausible that the U.S. economy is following the sequence of events that pushed Japan into deflation than what transpired in the United States in the 1960s and 1970s.  Even if the U.S. economy has more inflationary potential currently than realized, it seems likely that there will be plenty of lead time for officials to recognize the warning signs in the behavior of money growth, real GDP, and inflation.  Officials will be able to implement corrective measures and avert high inflation, which in the 1970’s took many years of previous neglect to create.

Copyright Larry Greenberg 2010.  All rights reserved.  No secondary distribution without express permission.



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