The Federal Open Market Committee voted to raise interest rates by 75 basis points this week in its efforts to tame inflation in the US. (CNBC) The US hasn’t experienced inflation over 4% since around 1990, and current headlines always mention that we haven’t seen inflation this high since 1981. But is this comparison helpful?
Inflation in 1981 versus Now
We keep hearing that inflation is at levels not seen for 40 years. People are concerned about inflation, worried about increasing interest rates, and bets are now favoring a recession at some point in the not too distant future, especially after the second quarter GDP showed a 0.9% decline (CNBC). For anyone born since 1980, you haven’t experienced anything like this. And for many GenXers, the high inflation days were in their childhood before they may have been very aware of the economy. Below find a graph of Core PCE since 1960–the measure used most often by the Fed as a truer measure of underlying inflation.
Differences outnumber similarities between the two time periods in question. We can start with what was similar. Both periods were marked by an energy crisis. And folks were griping then as now about the Fed increasing interest rates. But even the headline inflation rates reaching levels not seen in 40 years needs to be put in context. The inflation rate for the decade up to 1981 AVERAGED 9%, compared to about 2% for the most recent decade. Interest rates were not being increased from zero but from something closer to the rate of inflation. Interest rates today are still well below the inflation rate we are currently experiencing. And mortgage rates exceeded 17% in late 1981—while mortgage rates today are just under 6%.
Of course, the flip side of the interest rate/inflation rate relationship then to now is that risk-free investments (Treasury bills and bonds) earned 400 basis points more than inflation in 1981, but today (except for I-bonds) they pay about 600 basis points less than the inflation rate.
For more comparisons, including a great collection of charts of all this data, check out A Wealth of Common Sense “The Last Time Inflation Was This High.”
The Fed Then versus Now
We have already discussed that high inflation was not a new phenomenon in 1981. But a key economic indicator—the unemployment rate–was much different in 1981. It was over 7%, about double the current unemployment rate. The economy was generally much weaker in 1981 compared to now. Paul Volcker, the Chairman of the Federal Reserve in the 80’s, aggressively raised interest rates to tame inflation. It took awhile, and the US suffered through two recessions in the process.
While the US is in a much stronger position as the Fed’s begins its fight against inflation with these current rate increases, the likelihood of a severe recession is less than it was forty years ago, but not out of the question. Taking a closer look at the Fed’s actions and economy’s responses in the 80’s might give us some insight into assessing the likelihood of a recession today.
Events of the 60s and 70s (The War on Poverty, the Vietnam War, the Yom Kippur war and resultant energy crisis, Nixon’s Wage and Price Controls, and the end of convertibility of dollars to gold) set the stage for the economy that Volcker inherited when he took over as Chairman in January, 1979.
This is how Vox explains the repercussions of the interest rate increases under Volcker.
That month (October, 1979), the Fed’s interest rate was set at 13.7 percent; by April, it had spiked a full 4 points to 17.6 percent. It would near 20 percent at times in 1981. Higher interest rates generally reduce inflation by reducing spending, which in turn slows the economy and can lead to mass unemployment. When the Fed raises interest rates, rates on everything from credit card debt to mortgages to business loans go up. When it’s more expensive to take out a business loan, businesses contract and hire less; when mortgages are pricier, people buy fewer homes; when credit card rates are higher, people spend and charge less. The result is less spending, and thus less inflation, but also slower growth.
Those early rate increases were enough to drive the economy into a recession by January of 1980, and thus the Fed backed off and lowered them. Then inflation roared back, and interest rates had to be increased again, leading to a more severe recession. By the time Volcker’s term ended in 1989, inflation was down to 3.4%, but there had been widespread pain felt across the economy.
The Fed’s recent interest rate moves have been fairly dramatic (75 basis points at the last two FOMC meetings), and the Fed is trying very hard for a “soft landing.” If you listen carefully to Jerome Powell’s post announcement press conference, he explained that some weakening of demand and softening of the labor market might be what is needed to tame the beast we call inflation.
- Looking through both articles, find five economic indicators and compare 1981 to 2022. How would you describe the relative strength of the economy then versus now? Which data comparison surprised you the most?
- Trace the impact of the increases in the Federal Funds rate on individuals, businesses, and ultimately, the economy.
- Do you feel we are headed for a recession? Why or why not? Did examining the experience of the early 1980’s influence your opinion?
For a more detailed activity on the most recent FOMC, try NGPF’s More Interest Rate Increases: Federal Reserve July Press Conference Activity.