The Inevitable Fed-Induced Recession

A s the Federal Reserve continues to tighten rates in response to inflation, it seems that we may already be in the midst of a recession. The Bureau of Economic Analysis just revised the GDP figure for the first quarter of 2022 to an annual rate of -1.6 percent while the Atlanta Fed’s “nowcast” estimate for the second quarter of 2022 is at -1.9 percent.

Should the latter number prove accurate (or anything like it), the economy would meet one definition of recession, as it would have undergone two consecutive quarters of negative GDP growth. Financial markets are already being hit by the prospect of an economic slowdown (equity-market indices like the S&P 500 have taken a hit of almost -20 percent in the first half of 2022). It seems as if the only question remaining is how severe the recession will be. In part that will be determined by how much tightening will be required to bring inflation back to the Federal Reserve’s 2 percent long-run target.

It’s hard to dispute that this recession will be in some part due to the Federal Reserve’s monetary policy.

For the most part, post-war U.S. recessions have fallen into one of three types: Fed-induced recessions (the Fed raising rates to quell inflation, such as during the recessions of the 1950s, 1960s and 1980s, and early 1990s), bursting asset bubbles (like the tech bubble in 2001 or the housing bubble of 2008), or an exogenous shock, whether the twin oil shocks of the 1970s or the recent pandemic. This new 2022 recession looks as if it will mainly represent a return to the first type of recession, a Fed-induced recession.

Perhaps surprisingly, there is some debate as to whether Fed tightening can induce severe recession (some might argue that the past recessions were merely correlated with past rate hikes and that the rate hikes themselves were not their primary driver). In A Monetary History of the United States, Milton Friedman and Anna Schwartz argued that the Federal Reserve’s tightening of the money supply in the late 1920s and early 1930s was the primary cause of the Great Depression. Others dispute that claim (some point to the Smoot-Hawley tariffs or taxes, slowing technological progress, or shortfalls in aggregate demand and government spending). Some of today’s most brilliant monetary-economics scholars, such as Emi Nakamura and Jon Steinsson, have questioned whether the Fed might have been as responsible for those contractions as Friedman and Schwartz claimed (see their excellent article “Identification in Macroeconomics“).

Regardless, there are plenty of other examples that show how significant monetary contractions are typically followed by very deep recessions (while, of course, quelling inflation). For instance, in a 2009 Journal of Political Economy article, economic historian Francois Velde demonstrated that in France a significant cumulative 45 percent cut to the money supply in the early 1700s was followed by a 30 percent contraction in the industrial sector. Some also point to Paul Volcker’s raising interest rates to 20 percent in the 1980s and the subsequent recession as further evidence.

There’s also evidence that large monetary expansions can cause some real economic growth. For example, a recent Review of Economic Studies article shows how the European discovery of massive deposits of precious metals in the Americas caused an injection to the money supply in certain European countries in the 1500s and 1600s, spurring economic growth.

Despite what will likely be the pains of a Fed-induced recession, reducing inflation is an important and necessary goal. As we know from history, inflation can feed on itself if left untamed. And, it’s worth adding that those who are likely to bear the brunt of the worst of it — at least in terms of the rate of inflation that will affect them — will be the poor. It’s also true that the poor are hurt the most during recessions.

One accidental monetary experiment was carried out during the Civil War when, in response to rising inflation, the Confederate government decided to decrease its money supply by 33 percent in February 1864. Since key sections of the Mississippi River had then been captured by Union forces, the new Confederate dollars being circulated could not reach the western Confederacy (much of Louisiana, Arkansas, and Texas). In the western part of the Confederacy where there was no monetary contraction like in Houston (the new Confederate dollars meant to replace the old could not reach west of the Mississippi hence they continued to use the old), inflation continued to rise while in the eastern part of the Confederacy like in Richmond where the demonetization was able to take place, inflation slowed substantially (although it eventually shot up again later on toward the end of the Civil War).

In some of my own forthcoming research, I show that there was also a deeper economic contraction in the eastern part of the Confederacy compared with the western parts.

That, of course, is an extreme example as is, in a very different way, Volcker’s successful eradication of inflation, but the message from history seems clear: Inflation is a monetary phenomenon, and monetary policy can affect economic growth, at least in the short run. With rising rates today in 2022 and inflation at 8.6 percent, an almost certain recession will be the price we’ll have to pay to eradicate inflation.