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John B. Carlson |

Vice President

John B. Carlson

John Carlson is a former vice president and economist in the Research Department at the Federal Reserve Bank of Cleveland. He retired in 2014.

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John Lindner |

Research Analyst

John Lindner

John Lindner is a former research analyst in the Research Department of the Federal Reserve Bank of Cleveland.


Economic Trends

Potential Risks Associated with an Itchy Trigger Finger

John B. Carlson and John Lindner

Recent comments on monetary policy have focused more and more on containing the inflationary risks posed by rising food and commodity prices. Certainly, there are economic concerns associated with the possibility of high levels of inflation, but there are still several risks to the nascent economic recovery that could make policy tightening a worrisome move in its own right. While there are no episodes in history that correspond directly to our current policy situation, some past experiences are worth reviewing.

Though history offers relatively limited guidance to today’s policymakers, two episodes catch one’s eye, both of which involve sudden increases in short-term nominal interest rates following an extended period of accommodative policy and steady bond yields. The first period occurred during 1937, as the three-month Treasury bill rate made a sudden 40 basis point jump in response to a deliberate policy action to combat a perceived change in trend inflation. The bill yield quickly receded throughout the remainder of 1937, as the economy slumped back into another recession during that year. More recently, the Fed made the surprise move of raising the fed funds target rate in late 1994. It was a move that induced a large decline in bond prices. Both of these examples offer potential insights into the possible outcomes that could result from a tight monetary policy in the near future, but both also need to be explained in a more complete context.

Starting with the 1937 example, comparing Depression-era economics to present day is challenging for a number of reasons, primarily because the economic policies were different along several dimensions. For example, in 1937, the Board of Governors doubled the reserve requirement after three changes in the span of one year, and the Fed had no clear Congressional mandate on the employment objective as it does now with its dual mandate, leaving inflation as the center of attention. The level of the CPI during that year was still nearly 15 percent below its pre-Depression peak, and real GNP had just recovered from the downturn that started in 1929.

The current situation is a bit different. Just recently, real GDP climbed back to its previous peak, but the CPI is over 5 percent above its pre-recession level. Much like the economic environment in 1937, though, several sectors of the economy (including housing) remain much weaker than prior to the contraction. It should also be noted that the real rate of interest still hovers around -2 percent, much like the real rate in 1937.

Perhaps the most important thing to note about the 1930s was that the sharp increase in the Treasury bill rate was concurrent with tighter fiscal policy. As highlighted in a 2011 study by Christina and David Romer, the Great Depression dried up the federal coffers. Expenditures grew as revenues stagnated, forcing the government to run annual budget deficits consistently near 5 percent of GDP from 1932 to 1936. These deficits were counteracted by nine separate Revenue Acts from 1932 to 1940, including acts in 1934, 1935, and 1936. Romer and Romer estimate that those three Acts added revenues of between 0.37 percent of GDP to 0.74 percent of GDP. Also in the three-year period directly preceding the 1937 downturn a large chunk of the taxes enacted within the Revenue Acts were corporate tax hikes. Corporate tax hikes would not only have pass-through effects on consumer prices, but would also discourage investment and innovation.

Net Federal Fiscal Year Deficits


Federal deficit
(millions of dollars)
As a percentage of GDP
Estimated federal deficit without Revenue Acts (millions of dollars)
As a percentage of GDP

Source: Romer and Romer, 2011.

Compare these numbers to today’s situation, where the federal deficit for the past two years has averaged 9.5 percent of GDP. Revenues have fallen and expenditures have been expanding, fueling calls by deficit hawks to reverse the imbalances.

In light of the European sovereign debt crisis, these warnings about large and persistent deficits can hardly be ignored. But the historical data that we do have on federal deficits suggest to us that the economy should be on a clearly sustainable growth path before the necessary fiscal reform begins in earnest. The historical data should also warn policymakers that if the fiscal side decides to tighten its belt, the monetary authorities will have to consider the economic consequences of those actions when making their own policy.

The years following the 1990-91 recession can also offer a valuable lesson. Interest rates, as measured by the three-month T-bill rate, fell during and after the recession before settling down from 1992 to 1994 at nearly 3 percent. By that time, the economic recovery from the recession had been well-enough established, as real GDP was almost 8 percent above the pre-recession peak. Unlike the current situation, the economy had reached annual growth of over 4 percent in three consecutive quarters by 1994. The recovery today is much softer; saying we have experienced even one solid year of growth may be questionable depending on the definition one applies to solid growth. As highlighted in the chart below, core inflation rates were much higher in the early 1990s as well, hovering near 3 percent. Today’s core inflation measures still sit near 1 percent. Moreover, the current recession was borne of a financial crisis, and consumers and businesses might need even more time to rebalance their finances.

The most relevant aspect of the 1994 episode relates to concerns about accelerated inflation. Core consumer prices continued to increase at a clip above 3 percent, and, after long spells of core inflation rates above 10 percent in the mid- and late-1970s, keeping inflation in check was undoubtedly a top priority for the Fed of 1994. During the recession and recovery, core rates had climbed up over 6 percent, and lingering core inflation near 3 percent pushed the Fed into action. The first federal funds rate hike occurred in February 1994, when the Fed announced that it would be increasing the target rate. The fed funds rate was increased seven times during the next year, eventually reaching 6 percent. The series of rate hikes had a profound effect on long-term rates, spurring what became known as the “Bond Market Slaughter.” Clearly, the major difference between the current circumstances and those in 1994 relates to the transparency that the Fed uses in its policy decisions.

February 1994 was the first post-meeting statement in a series of increasingly informative announcements made by the FOMC about its interest rate decisions. Markets were unprepared for the first move, and market participants showed their shock in large selloffs of bonds. Any interest rate decision in our current environment will surely be communicated in advance, especially now that Chairman Bernanke will be conducting post-meeting press conferences.

Still, there are major lessons to be learned from a policy action that is predicated on concerns for inflation. The stronger footing of the economy in 1994 probably weathered most of the storm, but a large bond selloff in today’s financial markets could induce panic. As Europe tries to right their budgetary ships and heightened risk aversion remains, a panic could short circuit the current recovery. Also, it is important to put the inflation rates into perspective. In 1994, core CPI inflation was around 3 percent in the context of a strong economy. Today, core CPI inflation is still near 1 percent in an economy that still has weak employment growth. Combined with the calls for fiscal austerity, rate increases motivated by rising price measures seem premature at this stage.