The Federal Open Market Committee voted to raise interest rates by 75 basis points this week in its effort to curb inflation in the US. (CNBC) US inflation hasn’t been above 4% since about 1990, and today’s headlines always mention that we haven’t seen inflation this high since 1981. But is this comparison useful?
Inflation in 1981 vs. now
We keep hearing that inflation is at a level it hasn’t been in for 40 years. People are worried about inflation, worried about rising interest rates, and are now betting on a recession at some point in the not-too-distant future, especially after GDP showed a 0.9% drop in the second quarter (CNBC). For those born since 1980, you haven’t experienced anything like this. And for many GenXers, the days of high inflation were in their childhood, before they may have had much knowledge of the economy. Below is a graph of Core PCE since 1960, the measure most often used by the Fed as a more accurate measure of core inflation.
The differences outweigh the similarities between the two time periods in question. We can start with what was similar. Both periods were marked by an energy crisis. Then, as now, people bemoaned the Fed’s rate hikes. But even headline inflation, which is reaching levels not seen in the past 40 years, must be seen in context. THE INFLATION RATE AVERAGED 9% FOR THE DECADE PRIOR TO 1981, COMPARED TO ABOUT 2% FOR THE LAST DECADE. Interest rates were raised not from zero, but from something closer to the level 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 downside of the interest rate/inflation rate relationship since then is that risk-free investments (T-bills and bonds) earned 400 basis points more than inflation in 1981, but today (excluding I-bonds) they pay about 600 basis points below the rate of inflation.
For more comparisons, including a large collection of charts of all this data, check out Abundance of Common Sense »The last time inflation was this high.”
The Fed then vs. now
We have already discussed that high inflation was not a new phenomenon in 1981. But the key economic indicator – the unemployment rate – was much different in 1981. It was over 7%, roughly double the current unemployment rate. The economy as a whole was much weaker in 1981 than it is now. Paul Volcker, chairman of the Federal Reserve in the 1980s, aggressively raised interest rates to curb inflation. It took a while, and the US suffered two recessions in the process.
Although the US is in a much stronger position as the Fed begins to fight inflation with these current rate hikes, a major recession is less likely than it was forty years ago, but not out of the question. A closer look at the actions of the Fed and the reaction of the economy in the 80s can give us some insight into the assessment of the likelihood of a recession today.
The events of the 1960s and 1970s (the War on Poverty, the Vietnam War, the Yom Kippur War and the resulting energy crisis, Nixon’s wage and price controls, and ending the convertibility of dollars into gold) laid the foundation for the economy that gained in Volcker’s legacy when he took over as chairman in January 1979.
Here’s how Vox explains the implications of raising interest rates under Volcker.
That month (October 1979), the Fed’s interest rate was set at 13.7 percent; by April, it had grown by as much as 4 percentage points to 17.6 percent. Sometimes in 1981 it was around 20 percent. Higher interest rates usually reduce inflation by cutting 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 and business loans go up. If a business loan is more expensive, businesses contract and hire less; when mortgages are more expensive, people buy fewer houses; when credit card rates are higher, people spend and charge less. The result is less spending, and therefore less inflation, but also slower growth.
These early rate hikes were enough to send the economy into recession by January 1980, and so the Fed backed off and cut them. Then inflation flared up and interest rates had to be raised again, leading to a more severe recession. By the time Volcker’s term ended in 1989, inflation had fallen to 3.4%, but there was widespread pain throughout the economy.
The Fed’s recent interest rate moves have been quite dramatic (75 basis points at the last two FOMC meetings), and the Fed is trying hard for a soft landing. If you listen closely to Jerome Powell’s press conference after the announcement, he explained that some easing in demand and a softening of the labor market may be what is needed to tame the beast we call inflation.
The idea of the lesson
Have students read both Vox and An abundance of common sense articles and address the following:
- Looking through both articles, find five economic indicators and compare 1981 to 2022. How would you describe the relative strength of the economy then and now? Which data comparison surprised you the most?
- Trace the impact of an increase in the Federal Funds rate on individuals, businesses, and ultimately the economy.
- Do you feel we are headed for a recession? Why or not? Has studying the experiences of the early 1980s influenced your opinion?
For more details on the latest FOMC, try NGPF More interest rate hikes: July Federal Reserve press conference.