Is our economy headed back into a recession? A look at a past double-dip, the recessions of 1980 and of 1981-1982, suggests we are due. That double-dip also suggests the Federal Reserve should raise interest rates earlier and faster than you might think.
In fact, the 1980s experience points to something horrible: We need a recession to get a true recovery.
The trouble that time actually started in the 1960s. Back then, policy makers feared inflation less than a recession. Scholars alleged they knew how to manage "creeping inflation" before it morphed into "galloping inflation," the unstoppable animal. A famous economic textbook at the time, written by Paul Samuelson, claimed that inflation was all right as long as it stayed below 2 percent. John Kenneth Galbraith deemed inflation "a normal prospect." The view was that oil shocks, loose monetary policy, taxes, deficits and labor strikes were also mere obstacles to grow past.
In the mid-1970s, the inflation rate — measured using the Consumer-Price-Index value for urban consumers — crept above 5 percent, and it seemed to want to stay there.
Federal Reserve Chairmen Arthur F. Burns and G. William Miller tightened interest rates repeatedly over the decade's course, so that the prime rate, the interest rate charged by banks to creditworthy customers, climbed from 8.5 percent in February 1970, when Burns began in the job, to an astounding 11.75 percent in early August 1979, when Miller left office.
Nonetheless, Burns and Miller both made clear they would always be mindful of a recession when setting interest rates. "They didn't want to make credit so easy as to fuel further inflation, but they didn't want to make it so tight as to choke the economy into another recession," as Alan Greenspan later put it.
The inflation rate moved above 10 percent regardless of the Fed's rate increases. This was partly because of energy prices, but only partly. The deeper problem was a shift in attitude.
Prices don't merely reflect what people think things ought to cost today; they also reflect what people expect items to cost tomorrow. Markets suspected that the future contained less growth and more inflation than advertised. They also suspected that the Fed would always hesitate to raise rates out of fear of hurting growth.
That suspicion was reinforced in 1978, when President Jimmy Carter signed the Humphrey-Hawkins Act, which mandated that the Federal Reserve strive for both full employment and stable prices.
Then, in the summer of 1979, with the inflation rate exceeding 10 percent, Carter appointed the inflation hawk Paul Volcker as Fed chairman. Whether Carter knew what he was doing is debated to this day.
For weeks, Volcker worked hard to build consensus within the Fed for raising rates. He also summoned the Wall Street Journal's opinion editors, Robert Bartley and George Melloan, to lunch in the dining room of the New York Federal Reserve Bank to try to win their support. Then he held an unusual Saturday meeting of the Fed's board of governors on Oct. 6. Afterward, the Fed announced it would raise the discount rate, which it charges banks that borrow at its window, to 12 percent.
When this news was announced that night, not everyone understood its importance. Pope John Paul II was visiting the U.S. at the time, and CBS asked the Fed spokesman, Joe Coyne, if their announcement mattered. "You'll remember this long after the pope has left town," Coyne told the network.
Coyne was right. For what Volcker was really saying was: "We are not afraid to force recession, whatever the statute says. Our only job is to stop inflation."
The Journal spelled it out the following Monday in an editorial bluntly titled "Support Mr. Volcker":
"The new Federal Reserve anti-inflation package is the most hopeful economic policy in decades," wrote the Journal's editors. "Since 1965, inflation has ratcheted ever higher … It is past time for a decisive step to break that spiral, and Mr. Volcker's package is the best hope we have."
Volcker used his monetarist cover to tighten violently. Between summer 1979 and December 1980, the prime rate rose to 21.5 percent from 12 percent.
Why so high? To wring extra money out of the economy, certainly, but also to prove the Fed meant what it said. Volcker incurred the wrath of many. Homebuilders sent the Fed two-by-fours to symbolize the houses they were not building; car dealers sent in keys to unsold vehicles. "We were negotiating for a house when Mr. Volcker came along and knocked the struts from under us," a husband told the New York Times in 1980.
In the second dip, which officially began in summer 1981 and ended late in 1982, unemployment rose past 10 percent. "That recession resulted from the absolute necessity to kill inflation," George Melloan told me.
The Fed didn't move the discount rate below 5 percent until the 1990s.
Eventually, people became convinced that the U.S. was serious about inflation. And the lower interest rates that followed enabled millions of Americans to build, invest and buy homes. Volcker's work made the work of future presidents, Republican and Democrat, easier.
Inflation hasn't dominated our headlines yet. But this moment resembles the old days because the Fed has made clear it's willing to tolerate inflation out of concern over a recession. No one today can imagine Fed Chairman Ben Bernanke raising rates to even the levels of the Burns era.
The first takeaway message from the early 1980s is that creeping inflation gallops before experts catch it. The second takeaway is that postponing the commitment to tighten hard ensures yet higher interest rates later.
A monetary recession lurks ahead. How high will the rates be? Higher than you think.
(Amity Shlaes, a senior fellow in economic history at the Council on Foreign Relations and a Bloomberg View columnist, oversees the Echoes blog. The opinions expressed are her own.)
© Copyright 2011 Bloomberg
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