1967 and 2008: Two botched policies

By Scott Sumner.

"I've occasionally done blog posts explaining how it's possible to prevent recessions from occurring, even after they have begun. That's because a recession is dated from the point where output starts falling, but it's not considered a recession unless the decline persists for a considerable period of time. This is one reason why economists are so poor at predicting recessions. During the past three recessions, a consensus of economists failed to predict the recession until it was well underway.
It occurred to me that I failed to provide an example of a recession that was prevented after it had already began. Today I will do so.

In 1966 the Fed tightened monetary policy to slow inflation, which had recently been increasing. As a result, industrial production fell by 1.9% between October 1966 and July 1967.


But that's much less than the nearly 8% decline observed during the 1970 recession, which was itself fairly mild. We had no recession in 1967 because the Fed sensed a slowdown, and eased policy in the spring of 1967. Because of this action, unemployment merely nudged up from 3.6% in November 1966 to 4% in October 1967, before renewing its long decline.

Now let's look at industrial production during late 2007 and early 2008:


After peaking in November 2007, industrial production fell by only 2.2% over the next 7 months. Then after June 2008, output fell sharply, and by June 2009 was more than 17.3% below pre-recession levels. June 2008 is considered a recession period whereas July 1967 is not, primarily on the basis of what happened later.

Unlike in 1967, the Fed decided not to ease monetary policy in the middle of 2008, despite growing signs of recession. Indeed policy was actually tightened sharply, as the fed funds target was held at 2% from April to October, despite a rapidly falling natural rate of interest. If the Fed had eased aggressively in June 2008, then they might have entirely prevented a recession that technically began in December 2007. It wasn't too late!

The decline in output from late 2007 to June 2008 was too small to constitute a recession. Yes, the NBER eventually declared that the recession began in December 2007, but there would have been no recession to date in the first place if industrial production had risen in the second half of 2008, as it did in the second half of 1967. (I would add that the post-Lehman crisis might also have been milder, indeed Lehman might not have even failed.)

Ironically, the Fed made the wrong call in both 1967 and 2008. In 1967 the Fed should have allowed a (very mild) recession to occur, in order to prevent the "Great Inflation" of 1966-81 from occurring. That inflation did far more damage than a rise in unemployment to, say, 5% in late 1967. Indeed, a mild recession in 1967 might have made the 1970 recession unnecessary. In contrast, the Fed should have prevented the 2008 recession.

In 1967, the Fed was too worried about unemployment and not worried enough about inflation, whereas the reverse was true in 2008. The solution is to ignore both inflation and unemployment, and focus on keeping NGDP growing at a stable rate.

Even at the low point of the second quarter of 1967, 12-month NGDP growth was running at over 5.4%. There was no reason at all for the Fed to ease monetary policy. By the 3rd quarter of 1968, 12-month NGDP growth had soared to 9.9%---the Great Inflation of 1966-81 was underway. Now look at NGDP growth in early 2008:


In the second quarter of 2008, the 12-month NGDP growth rate was only 2.7%. Admittedly this data was not yet available to Fed officials in June 2008, but even the first quarter data showed only a 3.05% NGDP growth rate---far below trend.
So why did the Fed (passively) tighten policy in mid-2008, by keeping rates at 2% as the natural rate of interest plunged sharply lower? In a word, inflation. An economic boom in developing countries such as China pushed global oil prices to a peak of $146/barrel in mid-2008. In the US, 12-month (PCE) inflation rose to a peak of 4.2% in July 2008, far above the Fed's 2% target. (CPI inflation reached 5.5%). Even though the Fed was aware that oil prices were distorting the data, they were so frightened of losing credibility on inflation that they allowed monetary policy to tighten sharply.

The Fed should have focused on NGDP growth, which was falling to dangerously low levels. As long as NGDP growth is kept at a modest level, any rise in inflation due to soaring oil prices will be transitory. Indeed by the end of 2008, the 12-month PCE inflation rate had plunged to below 0.4%, far below the Fed's target. So one of the many causes of the Great Recession was the focus on inflation, when the Fed should have actually been focusing on NGDP growth. Indeed this mistake is now so obvious that it goes a long way toward explaining the rapid increase in support for NGDP targeting.

PS. I am indebted to Robert Hetzel for educating me on the situation in 1967. However he is not to blame for any mistakes in this post.

PPS. I recently read a very interesting Time magazine article from December 1965, entitled. "We are all Keynesians now". It's amazing how confident people were back then that we had it all figured out."