A little history lesson for all of us
One of the most important books to understand monetary policy and the Federal Reserve is a book that many economists have heard about, but few have read. It is Allan H. Meltzer’s “A History of the Federal Reserve”. One reason why it is not a widely read book is that it comprises three volumes running to a total of 2,136 pages. Luckily, we have read the book and here is what Meltzer has to say about the Fed’s reaction to the 1973 oil crisis:[1]
“The 1973-74 increase in consumer prices was the largest since 1947, following the end of wartime price controls. This time […] poor harvests abroad, and the increases in oil prices added to the underlying rate of measured inflation resulting from the excessive monetary and fiscal expansion of 1972. […] Using monetary policy to counter the price level increase from one-time reductions in the supply of food or fuel lowered the equilibrium price level by reducing aggregate demand. Reductions in both supply and demand induced reductions in output and employment. A proper policy response to the oil price increase would have recognised that it was a tax on oil users paid to foreign producers. To reduce the loss of welfare the administration could have reduced domestic tax rates. Or it could do nothing about the price level shock and allow it to pass through the economy. It was not a monetary problem…” [emphasis added]
In essence, what the Fed did in reaction to the October 1973 OPEC oil embargo was to chase inflation by raising rates, hoping to rein in excess inflation. But the oil price shock in 1973, just like the oil shock from the Ukraine war and large parts of the inflation shock of the last year were supply shocks. The higher oil prices alone would have led to a decline in economic growth and aggregate demand. By hiking rates, the Fed acted pro-cyclically, cooling the economy through higher borrowing costs just when the increase in cost of living and higher energy prices were already cooling it.
The result was a rapid decline in economic growth in 1974. Inflation declined and unemployment rates rose. Unfortunately, unemployment rates rose faster than inflation dropped since high wage inflation created an incentive for businesses to reduce costs through layoffs. Allan Meltzer again:[2]
“The recession was in its eighth month in July [1974]. [T]he nominal funds rate was three percentage points above the rate of the National Bureau peak [i.e. the beginning of the recession as identified by the NBER]. The unemployment rate shows one likely reason: it rose only from 4.9 percent to 5.5 percent during this period. That was about to change. The unemployment rate reached 6 percent by October and 7.2 percent by December. This ended the anti-inflation policy. The federal funds rate began to fall.”
Once unemployment began to rise, the Fed understood the recessionary pressures in the economy and quickly shifted gear from fighting inflation to fighting unemployment. The result was a recovery of the economy in late 1974 while inflation pressures had not been broken. The starting gun to the 1970s stagflation had been shot. For the next seven years the US economy would be mired in high inflation and low growth.
I will leave that here for you to ponder today’s Fed decision.
[1] Meltzer, A. H. (2009). “A history of the Federal Reserve”, vol. 2 (book 2), page 865.
[2] Meltzer, A. H. (2009). “A history of the Federal Reserve”, vol. 2 (book 2), page 882.