Fears of a recession are rising. Alan Blinder, former Vice Chairman of the Federal Reserve, compares the current environment to the big inflation surge in the early Eighties and the economic downturn at the time. He says what’s different today and what’s next for interest rates.
Inflation was the big topic for markets this past year. Looking ahead to 2023, concerns about the economy are increasingly coming into focus. In the United States and Europe, a recession seems all but certain. The question is how bad the downturn will be.
The Market NZZ talked about these developments with Alan Blinder. The Professor of Economics and Public Affairs at Princeton University and former Vice Chair of the Federal Reserve Board has recently published a new book on modern U.S. economic history which tackles the shifting relationship between fiscal and monetary policy from John F. Kennedy to Joe Biden.
«The recession that we are probably going to have looks likely to be mild,» Mr. Blinder says. «This is not looking like a replay of 2008 or anything remotely close, or, going back to Volcker, a replay of 1982».
In this in-depth interview which has which has been lightly edited, Blinder draws parallels, but also cites differences between today’s environment and the early 1980s, when then Fed Chairman Paul Volcker fought inflation relentlessly and pushed the U.S. economy into recession. He explains why the current situation is less difficult for Fed Chair Jerome Powell. And he says what’s next for interest rates and monetary policy.
Professor Blinder, your new book chronicles the history of fiscal and monetary policy in the U.S. from 1961 to 2021. Why did you choose those sixty years as time frame?
Well, the endpoint was easy because that was as far as I could go. The beginning point was also easy in two senses. First, 1960 was where Friedman and Schwartz’ «Monetary History of the United States» ended. Second, it was also the beginning of Keynesianism in America; not in the intellectual world, but in the policy world with the Kennedy administration coming in in 1961. So it was a natural starting point.
How did this change economic policy?
Essentially, there was nothing that we would call fiscal policy prior to that time. Of course, there was a budget, government spending and taxing, and that goes back to the beginnings of the Republic. But people in Washington were very rarely, if ever, thinking of using those instruments of fiscal policy – taxation or spending – to make the economy either grow slower or faster. That’s what we mean by fiscal policy these days. It’s a common place now. But if you went back to the time before Kennedy, there was hardly any thinking of that nature in the US. A number of European countries were ahead of us. For instance, the Swedes had been doing it since the Thirties, but not the Americans.
And what were the consequences of this?
As I said, Keynesianism came to Washington with JFK, and when he was assassinated, this transformation was really completed by his successor Lyndon B. Johnson. In those days, it was thought that stabilization policy was mostly fiscal policy, and that monetary policy was kind of a passive partner. The term «accommodative monetary policy» comes from that period.
So monetary was just playing second fiddle?
If the fiscal authorities wanted to cut taxes, they didn’t want that to push interest rates way up, so the people at the Federal Reserve were supposed to accommodate fiscal policy by stabilizing interest rates. But they were not the active participants. During the research for my book, I even dug up an amazing quote from the 1968 Economic Report of the President stating: «The control of inflation is the responsibility of fiscal policy, not monetary policy.» Just imagine that! Nobody would say something like that today.
Already at the time of the World War II, the Federal Reserve was de facto demoted to an extension of the Treasury. In the recent past, however, it has mostly been up to monetary policy to support the economy in periods of weakness. How did this happen?
I’m skipping over a lot of episodes, but after the huge Reagan tax cuts in 1982-84, fiscal stabilization policy basically disappeared for over twenty years. Sure, there was fiscal policy, there were budgets, there were taxes, there was spending. But the people in authority were not looking to fiscal policy to manage the economy. For twenty years, the job of fiscal policy was basically to «get the budget deficit down», so much so that we had a recession in 1991 during the presidency of George H.W. Bush and not a soul advocated for fiscal stimulus to help shorten the recession. Everyone looked at the Fed.
In the financial crisis of 2008/09, but especially with the massive stimulus packages following the outbreak of the pandemic, fiscal and monetary policy have again increasingly worked together. Are we currently experiencing some sort of revival of the 1960s?
Absolutely. The belief in Keynesian economics has had peaks and valleys over the past sixty years. Today, I think Keynesian theory is on the rise again – not so much in rhetoric but in actions. If you look at how the world reacted to the crisis in 2008 and 2020, that was Keynesianism big time. No country said «I’m going Keynesian here». But they did go Keynesian again in a big way.
How do you explain this reversal?
Around the world, the last two episodes led to such deep recessions that the choice of who plays first fiddle and second fiddle between fiscal and monetary policy became silly. It was basically «get the whole orchestra», everybody has to pitch in to try to get the US economy, the British economy, the Swiss economy out of the hole. So fiscal and monetary policy, even with independent central banks, were working hand in glove, pushing in the same direction. The question is how long that lasts.
The answer to this question may soon be revealed, as a further downturn is on the horizon for next year. How big is the risk of a recession?
In Europe it’s for sure that we will have a recession in 2023. In the US it’s not definite, but fairly likely. So I’m worried that if we have a recession, the job of pulling the economy out of the recession is going to be completely left to the Fed.
We’re not going to get a big fiscal response for two main reasons: First, the deficit remains huge from the previous episode. It’s shrinking from titanically large to just gigantic, and that’s a deterrent for fiscal policy. Second, starting in early January, the House of Representatives will be in the hands of a Republican majority, and they show no inclination whatsoever to be cooperative in any way. In fact, they are more likely to make things worse by threatening the US to have a technical default on its debt because of the silly debt ceiling. People talk about American exceptionalism, and when Americans talk about it it’s usually the good things. But there are a few really silly things, and the debt ceiling is one of them.
Does this mean the Federal Reserve will once again print money on a grand scale if the economy does indeed slide into recession?
In the first instance it will be about cutting interest rates. Maybe that will be the whole story, depending on how severe the recession looks. Right now, the Fed is raising interest rates, and by the time it finishes raising, the short-term rate of interest may be 5% or something like that. This will give the Fed a lot of room to come down. When the pandemic hit, the short-term rate of interest was 1.75%, so the Fed didn’t have much room to come down. So this time, lowering interest rates will hopefully be enough.
The Fed has raised interest rates at a rapid pace to 4.5%. It is also withdrawing liquidity from the financial system by shrinking its balance sheet. This is fueling fears of a hard landing of the economy. What’s your take on this? Are policy makers committing a mistake?
I don’t think so. The Fed has learned and internalized some important lessons of history. One of which is that the effects of monetary policy on the real economy work with long delays, and on inflation the delays are even longer. It’s like if you have a headache, and you take two aspirins. Two minutes later, you still have a headache, but you don’t immediately take two more aspirins. So the Fed applies this medicine, trying to slow down the economy to get rid of inflation, and it takes a long time to work. You have to pay attention to that in order not to overdose the economy.
So what will happen next year regarding monetary policy?
I take a lot of solace in the fact that many people on the Federal Reserve, starting with Jerome Powell but not limited to him, are talking quite forthrightly about that hazard: that there are long lags in the effects of monetary policy. They say: we don’t want to overdo it. And that’s a very important thought for them to have in mind. So I think we’re a lot closer to the end of this tightening cycle than to the beginning, and they seem very cognizant of that.
Fed Chairman Powell is visibly trying to create an image for himself as a strict inflation fighter like Paul Volcker in his day. To what extent can today’s environment be compared with the time forty years ago when Volcker headed the Fed?
There are a few parallels, but more very big differences. Let me start with the parallels: First of all, what’s happened recently and is still happening in the United States is the highest inflation rates we’ve seen since the early Eighties. So this is very historical for the United States, this is not a country that runs 6%, 8% or 9% inflation rates frequently, and back then inflation was even higher. The second parallel is that oil shocks and food shocks were an important driver of inflation back then and also recently. We had these kinds of shocks frequently and large back in the 70s and 80s, then for a long time not so much. But lately, in the last couple of years, we experienced serious oil shocks and food shocks; the last round of which were driven by Russia’s invasion of Ukraine. But now, that’s already gotten better, oil prices are way down.
And what are the main differences from the Volckers era?
One thing that is obvious in the current episode, but had no parallel forty years ago, were the supply chain disruptions around the world as economies came out of their Covid comas. That had no parallel back then. And by the way: China is re-opening its economy just now, so this process is not completely over. However, there are three more crucial differences. The first one is about yanking down the core inflation rate which excludes food and energy prices. In the early Eighties, Paul Volcker needed to knock about six percentage points off the inflation rate. This time, Powell needs to knock off about two percentage points - and that’s a much easier job.
For most people, however, the prices of energy and food are important. Is it reasonable to consider only the core rate of inflation in such comparisons?
These are real prices, I know. People buy fuel, they buy food. So if you’re thinking about how much pain and suffering inflation is inflicting on the population, you want to include food and energy. But when you think about what the Fed can do to bring inflation down, it can’t do anything about oil or food prices. It can do things about the rest, and that’s represented in the core inflation rate.
What’s the second and third difference compared to the inflation surge in the early 1980s?
Importantly, inflationary expectations have not jumped upward. Over one year of course, people have their eyes open and they see what’s happening. But over five- or ten-year horizons inflationary expectations as registered in financial markets are not high. They really haven’t moved very much. That was not true when Paul Volcker became Chairman of the Fed. At the beginning of his tenure in 1979 they were sky-high. And when inflation is expected to run that high, it tends to get ingrained in contracts and wage settlements and things like that, making it much harder to pull inflation down. Powell doesn’t have to worry about that the way Volcker had to.
And where do you see the third difference?
Today’s labor market situation is much friendlier than the one facing Volcker. When Volcker was campaigning to bring inflation down, the economy was kind of «so-so». We had a recession in 1980 which was short but deep. It wasn’t a strong economy, and there was already high unemployment. Jay Powell started this tightening cycle late as many people say – and that is a fair criticism – with an unemployment rate of 3.5%. Also, the monthly payroll employment gains were around 500,000 a month. To put that into perspective: Just because of population growth, the number of jobs we have to create in America to keep the unemployment rate stable is under 100,000 jobs a month. So employment growth could come down a long way, before you’re causing hardship in the labor market. And the current 3.7% unemployment rate can go up substantially before we get to high unemployment. For most of American history a 5% unemployment rate would have been great. We may not even get that high in this slowdown.
Another question is how the White House will react if the economy weakens and people lose their jobs. Because of this, Ronald Reagan and Paul Volcker were on a collision course at that time.
When Reagan became president of the United States at the beginning of 1981, Volcker at the Fed had already been pursuing excruciatingly tight monetary policy since the end of 1979. So that’s already in place, and it’s slowing economic growth. Now, Reagan comes in, and he’s boosting economic growth with big tax cuts. That’s a clear clash between monetary and fiscal policy. One violin is playing a high note, the other one is playing a low note. Reagan himself was really quiet about it, but some people in his administration were not quiet about it. They were not happy about the Fed because they were trying to make the economy zoom, while Volcker was pursuing this tight monetary policy which was holding things back. Push finally came to shove in 1987 when the question was if Reagan would reappoint Volcker to another four-year term, and he didn’t.
How do you think the White House will react this time?
First of all, Joe Biden decided to keep Jay Powell in the job when Powell’s first term as Fed Chair came to an end in early 2022. What’s more, the president and his whole administration have been completely silent about criticizing the Fed. Just think about that. Suppose you were kind of a crass politician and the people are complaining about inflation. You could say accurately that it’s not our fault, and blame the Fed. There has not been anything like that out of the Biden team, nothing at all. And I don’t think there will be. One more point: I believe that the recession that we are probably going to have looks likely to be mild. So it won’t do that much damage, and it won’t take that much to get us out of it. This is not looking like a replay of 2008 or anything remotely close, or, going back to Volcker, a replay of 1982. So my guess is that the relationship between Powell and Biden will remain friendly and cooperative.
Nevertheless: In the past, the Fed has usually tightened interest rates until something in the global financial system broke. How great is the danger that something will break this time?
We can break something, but I think when we break something, it’s going to be something that we weren’t expecting. The obvious things are not going to break, and hopefully it will be small. One thing just did break: crypto. So far, the ripple effects of the crypto crash on the real economy rather than - what I call - fantasyland look to me about zero. There may be something else that will break under the pressure of higher interest rates. Yet, what we know for sure is that leverage in financial institutions is much less than it was in 2007. This is partly because the financial institutions learned a bitter lesson about what can happen when leverage turns around and bites you. Partly, it’s because of the regulatory regime that was put in after the financial crisis. That’s also why Jay Powell did not witness the kind of financial collapse after the outbreak of the pandemic that Ben Bernanke was confronted with.
Although the dollar has weakened somewhat recently, it is still at a significantly higher level than at the beginning of the year. Could the strong greenback once again become a problem for the international financial system as it was in the 1980s?
What happened to the dollar in the early Eighties was a gigantic appreciation. As a ballpark number, it went up 60% compared to a basket of major currencies. What happened recently is tiny in comparison. I think people make way too big of a deal out of it compared to what happened in the past. So yes, it’s the same direction, but the magnitude is just non-comparable.
Finally, a question about the big picture. The last forty years have been characterized by declining inflation and steadily falling interest rates. Are we now at the beginning of a regime change?
That’s a good question, and here’s my answer to that: ask me again in three years. I think there is a real chance, but it’s not a certainty, that we go back to a low inflation, low interest environment. Not the negative interest rates like in Europe, but to much lower interest rates than we have now. I think that’s modestly likely, but it’s not guaranteed. I do believe that the main central banks of the world, starting with the Fed, are going to beat inflation. If I thought instead that they were going to fail and that inflation rates in the US and in Europe over the next decade would run 6% or higher, that’s a whole different story. It’s not impossible, but I don’t think it’s very likely. It’s much more likely that we are going to get back around 2 or 3% inflation, and that’s the big story for interest rates coming down.