Fabricated Fairy Tales and Section 2A

To describe a small change in the fed funds rate as a grave policy error vastly overestimates the correlation between monetary policy and economic outcomes. Information about the stance of monetary policy offers surprisingly little improvement or meaningful impact on forecasts for GDP growth, employment growth and inflation. Likewise, the relationship between unemployment and general price inflation better resembles a scatter of birdshot than a well-defined ‘curve’ or a manageable policy framework.

– John P. Hussman, Ph.D., FT Op-Ed, The Fed policy error that should worry investors, Jan 26, 2022

Amid the overabundance of economic opinion, unexamined clichés, and unverified assertions, and nutrient-free word salad dispensed by talking heads on television, market observers, and even Federal Reserve officials, I often wonder how many of them have ever taken the time to carefully examine historical data. After all, one might think, this is their profession – literally what they do for a living.

Yet when one compares the claims that are regularly made about economics and finance with actual historical data, the only reasonable conclusion is that people seem more interested in having a common framework to describe their world than whether that framework is correct.

A small example: On average, how much does the rate of inflation fall in the first year of a recession, as measured by the core personal consumption expenditures (PCE) index? The answer is that it doesn’t. During the first year of 11 recessions since 1950, core PCE inflation has actually posted a very slight increase, on average. The main contributor to that positive average was a 4.9% acceleration in the rate of inflation during the 1973-74 recession. The largest decline was -2.4% during the 1981-82 recession, as inflation retreated from a peak of over 9% in the core PCE price index and nearly 15% in the consumer price index (CPI). Inflation does fall during most recessions, but not by much. The median decline in core inflation in the first year of those 11 recessions was just -0.6%.

The change in core inflation during the two-year period following the beginning of a recession has averaged just -0.4%. The median decline was -0.7%. The single largest decline was -3.9%, as inflation retreated from the record highs that preceded the 1981-82 recession.

If we examine the change in core PCE inflation strictly from the beginning of a recession to its end, core inflation has not changed at all, on average. The median change is also zero. Shifting the window backward or forward by a few quarters doesn’t materially change these results. If we examine the average change in core inflation during the one-year period starting at any point during a recession, the average change is -0.4%.

To say that “monetary tightening reduces inflation by throwing the economy into recession” is to reveal that one has not examined the data. Much of that belief is driven by the 1981-82 period, when Paul Volcker tightened monetary policy to combat record inflation. But it was not recession in itself that broke the inflationary cycle. The essential victory of the Volcker Fed was to restore public confidence in monetary restraint and systematic monetary policy. Volcker did that by reducing the Federal Reserve’s balance sheet to the lowest fraction of nominal GDP in history. It was this restoration of public confidence, not recession per se, that brought down the rate of inflation so sharply. On average, recessions have no such effect.