An analysis of Fed exit strategies from previous recessions

Michael Bordo and John Landon Lane have written a super paper looking at how Fed has exited from various recessions.  They look at all the US recessions from 1920-2007. They first look at what Fed did in all those recessions and then how it exited from recessions.  The exit is basically when Fed started raising rates and looking at what macroeconomic variables. In exit policies they use both narrative evidence and econometric exercises.

The findings are quite amazing:

We find, based on historical narratives, descriptive evidence and econometric analysis, that in the 1920s and the 1950s the Fed would generally tighten when the price level turned up. By contrast, since 1960 the Fed has generally tightened when unemployment peaked and this tightening often occurred after inflation began to rise. The Fed is often too late to prevent inflation.

And then it is not as if inflation has been low in all post WW-II era:

An important fact to note is that since the mid 1960s inflation increased and became persistent for close to 20 years. In those cycles the timing of the tightening doesn’t show that the pace of tightening was not sufficient to reduce the rising trend in inflation. Since the mid 1980s during the Great Moderation although inflation was reduced significantly the timing of policy tightening still favored unemployment.

Why would this be?

There are several possible reasons for these patterns:

  • First, in the interwar the Fed followed gold standard orthodoxy which placed primary importance on price stability.
  • Second, after World War II and the Employment Act of 1945, the Fed followed a dual mandate for price stability and high employment.
  • Third, beginning in the 1960s the Fed adhered to Keynesian theories and the Phillips Curve which attached primary importance to low unemployment over low inflation.
  • Fourth, the dominance of unemployment in the timing of tightening in the postwar reflects in addition to Keynesian theory, political pressure by the Congress and the Administration on many occasions to not tighten while unemployment was unacceptably high.
  • Fifth, even in the Great Moderation era since the mid 1980s, after inflation had been significantly reduced and considerable emphasis has been placed on the importance of a credible nominal anchor, the timing of exits favors unemployment. This was evident in the last two cycles. In both cases of jobless recoveries political pressure may have been important.

Very interesting.

Most would assume Fed (and other central banks as well) would be increasingly looking at inflation as time moves. But no, we get to see unemployment remaining top priority as far as exiting is concerned. Political pressure seems to be a dominant point.

What about this crisis? Based on history authors note:

How will the exit strategy play out for the current cycle? The evidence in Section 5 suggests that if we follow the timing patterns seen in the postwar in the current cycle, and if unemployment peaks in the fourth quarter of 2009, that we may see a tightening in the first quarter of 2010 but more likely in the first half of 2010. Although if unemployment declines slowly from its current elevated level, political pressure and or the Fed’s experience from the last two recessions may stall the tightening longer.

Hmm. Lets see if authors predictions come out right. But yeah, we now know something about exit policies of Fed.


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