The Fed, Inflation, and Recessions

In my post last week I stated that recessions were often caused by monetary policy actions. Some people think it is bazaar if not evil to say such a thing. Policy is formed to create good outcomes – not recessions. But policymakers are just like you and me – prone to error and especially so when we think we are doing something for the greater good.

Since I sometimes write things based on what I think I know, I decided to bring up some data and see if there is any truth to what I think I know about inflation and recessions. But let’s first review the simple theory since it is relevant to current monetary policy.

     Monetary policymakers worry the economy is fragile so they keep interest rates low by letting the money supply expand faster than my belt at a July 4^th BBQ.

      In so doing they risk overheating the economy

     When the economy expands too quickly this leads to higher inflation

     Upon seeing higher inflation, the Fed restricts money, interest rates rise, aggregate demand contracts, and a recession ensues.

     Cinderella is then run over by her coach. Yes she was a little tipsy.

Looking at graphs never proves a theory but I am so old that I have forgotten how to run proper scientific experiments and besides, many of you are cynical enough to believe I faked the results anyway.  You can check or reproduce my results by going to the FRED data service at https://research.stlouisfed.org/fred2/  . Then choose the Consumer Price Index for All Urban Consumers: All Items. Then choose annual rates of change. That is what I call “inflation’.

I begin this story by looking at seven US recessions from 1970 to 2008. That means we are looking at almost 40 years of US history. If you want to go back farther that is okay with me but I figured that is enough years for our purposes here. These seven recessions are shown on the graph below as vertical shaded areas.

Inflation went from:

           less than 2.5% to more than 5% right before the 1970 recession started

           a little more than 2.5% to more 10% before the 1974 recession

           just over 5% to around 13% before the 1980 and 1982 recessions

           under 2.5% to over 5% before the 1992 recession

           about 2% to over 3% before the 2002 recession

           about 2% to about 4% before the 2008 recession

Every one of these seven recessions was preceded by a substantial and worrisome increase in the inflation rate.

That’s pretty interesting. Do I hear clapping in the background? But some of you sharp cookies (since when is a cookie sharp?) are saying stuff like the following. This proves nothing since Larry is focused on just two variables. If money is part of the story, then clearly I need to show the following – inflation was worrisome enough to elicit a Fed tightening of policy and that tightening caused the economy to contract. And the coup de gras (Charlie, coup de gras is not a race car) is that I need to show that nothing else was a major contributing factor to each of these recessions. For example, some of you smarty-pants will point out that the dot-com bust was a major factor causing the 2002 recession.

To the above I say raspberries (why is there a P in raspberries?). I could add more data but this is a family blog and I don’t want to pollute the environment.  I challenge you to do some simple search research with your favorite search engine using words like inflation, monetary policy, recession, 1980.  You will find it difficult to dismiss the strong possibility that too much money caused inflation and too much inflation caused tight money and ensuing economic contractions.

Which leads me to the following question: Does the future or at least the next few years have to imitate the last 40 years?

     Maybe that graph and all the discussion above is irrelevant for beyond 2015. 

     Maybe all that money injected recently will not ever cause higher inflation.

     Even if inflation does begin to rise, maybe the Fed won’t tighten vigorously

     Even if the Fed worries about rising inflation and tightens, maybe it won’t cause a recession

Since this blog is about you as much as me, I won’t answer those questions. But I am wondering what you think about them. Are we in a new world in which inflation is not a problem? Will that new world imply that the rules of money have been revoked? Will the Fed escape a period of historical monetary increases without causing a dent in the future economy? Does Janet Yellen know how to cha cha cha?