Circumstances and Results Surrounding Previous Times When the Fed Raised Interest Rates in Increments Greater than a Quarter Percentage Point

April 10, 2022

The last federal funds rate hike to exceed 25 basis points was an increase in May 2000 that culminated a tightening cycle of 175 basis points over a period of eleven months that began in mid-1999. The cycle commenced with the perception of a heightened inflation risk. CPI inflation at the time was only 2.0%, and the dollar was trading firmly against the newly created euro. However, U.S. GDP had expanded by a robust 4.7% in 1999, and unsettled financial markets had impelled Fed officials to cut rates in the second half of 1998. Four increases of the federal funds rate target between mid-1999 and February 2000 were all by the standard 25 basis points, but inflation had transformed from a potential risk to an actuality by March of 2000 inflation. The FOMC became concerned that productivity would not keep up with the rapid rise of aggregate demand. Consequently, the federal funds rate was hiked by 50 basis points that month and by a further 50 basis points at the following scheduled meeting in May by which point CPI inflation exceeded 3.0% and core CPI was almost  2.5%. Real GDP climbed over 4.0% again in 2000 in spite of the dot-com bear market, but a mild recession was experienced in 2001.

The Fed’s next tightening cycle covered two years between mid-2004 and mid-2006. It was not motivated by excessive inflation or even the emergence of worrisome inflation risk factors. A tightening cycle, rather, was justified because the federal funds rate was at a lowly 1.0% when the tightening began, and officials wished to restore a neutral interest rate level which neither would augment nor restrain economic growth. The idea was to achieve a steady and highly predictable path between points A and B, and so the federal funds rate was methodically lifted by exactly 25 basis points at each of 17 successive scheduled policy reviews, resulting in a 425-basis point cumulative increase to 5.25%. The dollar lost about 3% against the euro over those two years. The DJIA advanced by a moderate 6.6% on net, but the 10-year Treasury yield went up only 57 basis points, resulting in a considerable flattening of the yield curve in that period.

Another legacy of the 2004-2006 tightening was a dangerous rise in mortgage credit extended to high risk borrowers. Inflation often has roots in supply conditions, but the monetary policy tool used to promote stable prices works through the demand side, throttling the growth of such back to a pace that’s aligned with the growth in supply. If interest rates are raised slowly, steadily, and predictability, the impact on demand can be squandered. It’s like the fabled frog in a pot of slowly boiled water not having the sense to jump out. While not the only cause of the Great Recession, an unwillingness to interject some variation in the long string of interest rate hikes bears some responsibility for the economic catastrophe that followed .

And yet the next Fed tightening cycle, which began in December 2015 and ended in December 2018, also involved moves of only 25 basis points each instance. At least that time, officials varied the  intervals between rate hikes. The nine moves occurred in December 2015, December 2016, March, June and December 2017, and March, June, September, and December of 2018. The federal funds target range was 0.0-0.25% when this streak began, and CPI inflation was 0.7%. GDP had risen 2.9% in 2015 but then by only 1.6% in 2016 and 2.3% in 2017. Total  and core CPI inflation in December 2018 stood at 1.9% and 2.2%, respectively. Like the prior tightening cycle, the 10-year Treasury yield’s net rise (52 basis points) was much smaller than the cumulative climb of short-term rates, and the dollar on balance fell slightly against the euro, this time by 4%. Equities thrived, climbing 36% altogether.

The two monetary policy tightening cycles prior to the ones discussed above occurred in 1988-89 and 1994-95. Alan Greenspan was Fed Chairman in the earlier of those episodes, and he was pretty new in the position. Inflation of 4-something percent was still far above what’s currently accepted as price stability. Long-term U.S. inflation expectations were still very high. The 30-year Treasury yield had nudged above 10.0% in 1987, helping to trigger a 508-point and record single-day plunge of 22.6% in the DOW on October 19th of that year. Back then, there was no practice as now of the Fed immediately announcing the results of each FOMC meeting or, for that matter, even acknowledging and explaining changes in its stance when such  occurred. A succession of nine hikes of 25 basis points more or less were implemented between late March 1988 and early February 1989, and those increases in the federal funds rate from 6.5% to 9.25% was capped by the one and only 50-basis point increase late that month. This brought the total rate target increase to 325 basis points in the space of eleven months.

The modern rate tightening cycle that made the most use of larger-sized incremental changes occurred during the year from February 1994 to February 1995. From a starting level of 3.0% in the federal funds rate, the FOMC was motivated initially by a desire to return policy to a neutral stance after several years of stimulus. The three initial moves in February, March, and April were each ones of 25 basis points, but the subsequent four changes exceeded that norm. Strong economic growth justified increments of 50 basis points in both May and August of 1994, and by August with productive capacity fully stretched and inflation risks mounting, the funds target was jacked up by 75 basis points.  But officials weren’t done. Even thought economic growth in the U.S. slowed sharply between the second half of 1994 and the first half of 1995, the rate was lifted another 50 basis point in February 1995. In all the fed funds target was doubled to 6.0% in just a year.

None of the above examples of policy tightening quite resemble the circumstances that exist currently. Actual inflation is much higher this time than in those instances. Even though measures of longer-term inflation expectations are comparatively contained this time, officials cannot afford to be complacent. The more prolonged actual inflation stays far in excess of target, the likelier it is that consumers, businesses, wage-earners and investors will adjust their expectations to approach the overshoot. A concurrent problem is that in order to reduce inflation with higher interest rates, growth in aggregate demand has to drop either as a result of tighter monetary policy or for other reasons. Policy tightening tends to impact growth and prices with a lag, and expectations will be heavily influenced by whether policy seems to be adequately reacting to the high levels of inflation. For the same reason, policymakers cannot afford to take their foot off the brakes until well after they perceive that inflation is receding. That’s why policymakers in the U.S. but also at other central banks like to frame policy forward guidance in terms of a “sustainable” return to target.

All of which is to underscore that when inflation gets as high as it is now, not just in the United States but around the world, it became terribly difficult to restore and sustain price stability without bearing the cost of an unwanted recession. Alas, the closest historical parallel to the present at a glance involves the late 1970s and early 1980s. But a complication in making such comparisons is that Fed policy was conducted differently then. Two months after Paul Volcker’s term as Fed Chairman, the central bank changed its approach radically. Less emphasis would be placed on the Federal funds rate, he and colleagues decided, and more instead on the supply of bank reserves, and thereby monetary growth.

Even prior that that remarkable announcement, the Federal funds rate had risen from 4.7% at the end of the first quarter of 1977 to 11.6% by late in September 1979. That interval included a dollar rescue package announced in November 1978 featuring an unprecedented full percentage point hike in the Fed discount rate and a war chest of fresh resources to finance dollar support intervention. U.S. credit controls were imposed but then quickly lifted to abort a six-month recession in January-July of 1980. That double reverse allowed the Federal funds rate to tumble back to 8.75% by mid-1980 but boomerang to 19.75% by the end of the year. The U.S. economy was back in recession by July 1981 and would remain so until November 1982.

Fed officials concluded that the effectiveness of previous efforts to stamp out high inflation had been diminished by a tendency to let up on monetary restraint prematurely at the first sign of inflation and economic growth subsiding. The focus on bank reserves enabled year-on-year growth in the narrow M1 money supply to drop from 12.1% in April 1981 to 4.4% by April 1982. The discount rate was raised in percentage point increments from 10% in August 1980 to 14% by May 1981 and not cut until six months later. Bank prime rates went from just below 11% late in July 1980 up to 21.5% by Christmas that year and remained as high as 16.5% until mid-1982. From a peak of 14.7% early in 1980, CPI inflation did not fall sustainably below 10.0% until November 1981 but then halved to 4.6% a year later when the recession ended. The Dow Jones Industrial’s Average fell from 1,024 on April 27, 1981 to a cyclical low of 777 on August 12, 1982.

Regarding the U.S. currency, the steep drop in inflation amid very high interest rates and an expansionary fiscal policy ultimately doubled the dollar’s external value from around 1.70 German marks at the start of 1980 to DEM 2.57 by mid-August 1981 and eventually to DEM 3.48 in late February 1985. At the high point of U.S. inflation then, there was more divergence between the United States and Germany than is is the case now.

Copyright 2022, Larry Greenberg. All rights reserved. No secondary distribution without express permission.

 

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