The Fed is on the verge of repeating history by hiking rates much more aggressively. But rather than following in the footsteps of his revered predecessor, Paul Volcker, Fed chairman Jerome Powell, we believe, is emulating Alan Greenspan’s activist monetary policy approach from 1994. This holds lessons for all of us.
Before the economic boom of the 1990s, the US economy was emerging from a deep and protracted downturn. The bursting of the 1980s real estate bubble culminated in the banking industry’s most devastating collapse since the Great Depression. More than a thousand savings and loan associations failed, a third of the total.
The Fed responded to the crisis by cutting the fed funds rate from 8 percent to a record low of 3 percent from mid-1990 to late 1992. Although the recession ended in early 1991, businesses continued to lay off workers, pushing unemployment up to 7.8 percent in June 1992.
In 1993, the picture improved, particularly in terms of business investment and housing starts. The labor-market recovery picked up momentum, bringing the unemployment rate down to 6.5 percent. Some industries recorded their first sustained increase in jobs in several years.
With January 1994’s State of the Union address, President Bill Clinton made a persuasive case for why the US economy was finally waking up: “Auto sales are way up. Home sales are at a record high. Millions of Americans have refinanced their homes. And our economy has produced 1.6 million private sector jobs in 1993, more than were created in the previous four years combined.”
Consensus estimates of real GDP growth in 1994 were 2.9 percent. A 3 percent fed funds rate with 3 percent inflation was considered ultra-loose in this context. The Fed’s attitude was changing. Historically low interest rates were no longer necessary to stimulate spending and investment.
This, however, created a conundrum.
How gradually should the Fed reduce its accommodative stance, given that the recession and high unemployment were still fresh memories? How could it convey its message to the public when inflation looked to be under control? And what would be the ramifications of such a move, considering the Fed hasn’t tightened policy in five years?
“Short-term rates are abnormally low,” Fed chair A...