How does the Fed’s monetary policy response to the Covid-19 pandemic relate to historical experience?
The Fed has acted aggressively to shield the US economy from the Covid-19 pandemic. A reexamination of historical precedents is important to assess the Fed’s actions. Four historical episodes that intersect in a Venn diagram are salient in the current crisis: the Spanish Flu pandemic, 1918–19; the Great Contraction, 1929–1933; World War II, 1939–1945; and the Global Financial Crisis, 2007–2008.
Spanish Flu Pandemic, 1918–1919
The pandemic killed more than 50 million people worldwide and 675,000 in the US. There were two waves: in the spring of 1918, which began in army camps in the Midwest; and then in the fall, when the troops returned from World War I. No cures or vaccines were available. The highest mortality rate was in the working-age population (i.e. in people between ages 20 and 40).
The pandemic led to a mild recession. In the fall, industrial production dropped sharply and then bounced back quickly. Unemployment did not increase. Non-pharmaceutical interventions were implemented (e.g. the wearing of masks; the closing of schools and churches) but no mandated lockdowns. There was no monetary policy response.
The much milder recession reflected three things: a) a different economic structure (less urbanized, more primary and secondary production, and fewer services; b) World War I (the negative shocks to the labor force and consumption were offset by the war-stimulated demands of the government; and c) different attitudes to mortality, less advanced medical technology, and the experience of mass casualties.
The key lesson for today is that without the mandatory lockdown we might have had a milder recession driven only by the endogenous fear response on spending and hours worked.
The Great Contraction, 1929–33
The worst recession of all time exhibited a 35% decline in real output and in prices; unemployment peaked at 25%. Federal Reserve policy failed to prevent four serious banking panics.
The key lessons from that event are the need for aggressive monetary policy to stabilize the economy and for an effective lender of last resort.
World War II, 1939–1945
The war, like WWI, was a huge existential shock. It required massive government intervention to marshal resources for the war effort. The Fed became subservient to the Treasury financing its fiscal deficits and pegging both short-term and long-term Treasuries. The ensuing inflation was somewhat suppressed by wage price controls.
After the war, the Treasury pressured the Fed to continue its accommodative monetary policy and maintain the bond price pegs to prevent the recurrence of a post-war as had occurred after WWII. Instead, once controls were removed, pent-up demand fueled a rapid inflation of 15% per year between 1945 and 1948.The Fed pushed to regain its independence to fight the inflation, and finally achieved it in the Federal Reserve Treasury Accord in 1951.
The lesson for the Fed is that once the pandemic emergency comes to an end, it must reduce its expansionary policies to avoid a run up in inflation. To allay inflationary expectations, it should clearly spell out its exit strategy.
Global Financial Crisis, 2007–2008
As a student of the Great Depression, Chairman Ben Bernanke followed aggressive lender-of-last-resort (LLR) policies based on Article 13.3 to prevent the breakdown of the financial system. The Fed also followed expansive monetary policies until it hit the Zero Lower Bound when it adopted quantitative easing (QE) and forward guidance. These policies did temper the effects of the GFC, but it took a long time for the Fed to realize that the crisis was primarily a solvency—not a liquidity—event. The key action that ended the crisis was the stress tests of the major commercial banks.
The Fed’s LLR policies had serious spillover effects: a) a credit policy (which is really fiscal policy and involves picking winners and losers), which threatened the Fed’s independence; and b) moral hazard.
The Fed’s quantitative easing policies and forward guidance had only a limited effect in speeding up the recovery from the GFC. QE was hindered by paying interest on IOER and a poor communication strategy.
The lesson for today is that the Fed is using the same play book as it did in the GFC but has added in some new institutions and markets (e.g. corporate bonds and municipal bonds) to shield with its LLR policies. This suggests that the road of credit policy has gotten even wider and the threats to the Fed’s independence even greater. Moral hazard has also increased.
Moreover, basing its monetary policy efforts on QE and forward guidance again will continue to be of limited consequence. The Fed has rejected from its tool kit the use of negative rates, a tool which might actually be more potent.
In sum, the lessons from history never exactly repeat themselves but they often resonate, and not heeding them is perilous.
Michael D. Bordo is a Board of Governors Professor of Economics and director of the Center for Monetary and Financial History at Rutgers University, New Brunswick, New Jersey.
This post was adapted from remarks given at the Manhattan Institute's Shadow Open Markets Committee Event. The event can be seen in its entirety here.
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