The Fed Already Repeated the “Mistake of 1937”

Gautti Eggertson has an interesting post where he compares current economic conditions to those that prevailed leading up to the recession of 1937-1938. Here is his description of developments in 1937:

(1) Signs indicate that the recession is finally over. (2) Short-term interest rates have been close to zero for years but are now expected to rise. (3) Some are concerned about excessive inflation. (4) Inflation concerns are partly driven by a large expansion in the monetary base in recent years and by banks’ massive holding of excess reserves. (5) Furthermore, some are worried that the recent rally in commodity prices threatens to ignite an inflation spiral.

The Federal Reserve responded at this time by tightening monetary policy. Fiscal policy also was tightened. These policy moves turned what had been a robust recovery between 1933 and 1936 into the second recession of the Great Depression. As a result, a full economic recovery was postponed several more years.

Eggertson explains the surge in commodity prices was the galvanizing force then behind the concerns over inflation and, thus, the tightening of policy. Though these developments sound eerily similar to today’s environment, Eggertson is confident that Fed officials will not make the same mistake:

It is unlikely, however, that a modern economist put in the same position would respond to the commodity price rise in the same way… Fed economists today typically monitor various components of the CPI that are not influenced strongly by temporary supply disruptions. For example, one common measure tracked is “core CPI,” which excludes volatile food and energy prices from the overall CPI basket.

He then goes on to claim the Fed’s response in 2008 proves his point:

In early 2008, the economy started a downward spiral that culminated in a crisis… At the same time, however, there was a temporary rally in commodity prices, driven by a rise in oil prices in early 2008, as can be seen in the figure above. This development prompted some commentators to warn against “excessive inflation.” But Fed economists and many others judged that the rise in prices was specific to commodities and did not signal an increase in overall price pressures. Largely ignoring the temporary rally in commodity prices, the Fed focused instead on core inflation and some alternative price measures

I wish he were right, but the Fed has already repeated the mistake of 1937. As I and others have shown, monetary policy was passively tightening by mid-2008. A key reason is that the Fed was concerned about the very surge in commodity prices that Eggertson mentions above. In fact, it was so concerned it decided against lowering its target federal funds rate in its September, 2008 FOMC meeting. Here is an excerpt from the press release from that meeting (my bold):

The Federal Open Market Committee decided today to keep its target for the federal funds rate at 2 percent…

Inflation has been high, spurred by the earlier increases in the prices of energy and some other commodities. The Committee expects inflation to moderate later this year and next year, but the inflation outlook remains highly uncertain.

The downside risks to growth and the upside risks to inflation are both of significant concern to the Committee. The Committee will monitor economic and financial developments carefully and will act as needed to promote sustainable economic growth and price stability.

In short, the Fed’s inaction was driven by concerns that the surging commodity prices might push inflation too high. The Fed was looking to headline inflation in making this decision, not the core. Had they been looking at the core they would not have alarmed. Better yet, had the Fed been focused on the expected inflation rate from TIPS it would have seen that inflation expectations had been falling since July, 2008. Doing nothing, as it did, in such a setting amounted to passive tightening of monetary policy. So contrary to Eggertson’s claim, the Fed has already repeated the mistake of 1937 in 2008. It is not clear it won’t do the same again.

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