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When Will the U.S. Hit The 1947 Wall?
After a decade of financial struggle and a severe crisis in Europe that caused a massive ripple effect around the world, the United States found itself engaging in unprecedentedly loose monetary policy to finance public debt. You might have guessed I was describing the economy at the start of 2013, but despite financial prognostications that 2013 will be a good year for the U.S. economy, the parallels between the U.S. economy in 1947 and in 2013 are quite stark.
During and immediately after World War II, the Fed maintained extremely low interest rates in order to reduce war-financing costs for the government. As these policies became unnecessary and inflationary after the war, the Fed was compelled by the Treasury to maintain the low cost of debt. The result of this highly accommodating monetary policy was 14 percent inflation in 1947 and rising unemployment that persisted into the early 1950s.
Throughout this period, a series of battles took place between the Fed and the Treasury, with Congress coming to the Fed's aid and President Harry Truman backing the Treasury. These battles were marked by high political theater when newly elected Senator Paul Douglas (D-IL) held hearings to determine that the benefits of avoiding inflation were great enough to justify giving the Federal Reserve the freedom to raise interest rates, even though this increased the cost of servicing federal debt. Essentially, Senator Douglas clarified that controlling inflation trumped controlling federal debt. The White House and the Treasury rejected this assertion and continued to pressure the Fed to maintain low interest rates by citing the need to finance the Korean War.
As high inflation persisted all the way through 1950, Fed officials grew weary of political roadblocks to sound monetary policy and requested a meeting with the president. On Jan. 31, 1951, the entire Federal Reserve Board met with President Truman. At the conclusion of the meeting the President released the following statement: "The Federal Reserve Board has pledged its support to President Truman to maintain the stability of Government securities as long as the emergency lasts." The Fed Board had agreed to no such thing, and in the ensuing days financiers and economists from around the country came to their aid. When it was announced that CPI rose 14 percent yet again, Secretary of Defense James Forrestal was so alarmed with the rising costs of fighting the Korean War that he expressed support for the Fed to rein in inflation. This ultimately led to the 1951 Fed-Treasury Accord that is commonly believed to have granted the Fed independence. However, throughout the remainder of the Truman administration, Fed policy did not dramatically change. It was not until Eisenhower took office with a Fed-friendly Treasury and the end of the Korean War in 1953 that the Fed began to fight inflation in earnest.
This history provides an apt parallel to monetary policy in 2013. Many commentators have been claiming for months or even years that Fed policy is creating inflation or even hyperinflation. As of yet these predictions have not come true, but inflation expectations have certainly risen, and the amount of liquidity in the system creates the potential for high inflation. This parallel leaves us with two lingering questions: When will we hit the 1947 wall? And will the Fed be willing and able to act quickly and autonomously to rein in this inflationary pressure?
At this point, it remains unpredictable when the United States will hit the wall causing inflation to rise. However, with Europe slowly stabilizing, China resuming high single-digit growth, Japan engaging in stimulus and the U.S. real estate market rebounding, it appears as though the U.S. economy has turned a corner and may now be headed for the inflation so many hawks have feared. If this is the case, it is worth noting that there are pros and cons to driving down the value of the dollar and diminishing the U.S. debt load in real terms, but such a policy creates winners (debtors) and losers (creditors), as Menzie Chinn and Jeffry Frieden have explained. And if inflation does pick up, questions remain about if, when and how the Fed will engage to slow it.
The 1947 case demonstrates that Fed independence is a necessary prerequisite for stemming the inflationary tide. While some inflation hawks may question whether the Fed (or at least the Bernanke Fed) will ever be willing to tighten monetary policy and combat inflation, given the way in which stimulative policies have been begrudgingly adopted, indications suggest that Fed policymakers would be willing to stem the tide of inflation should significant pressure arise.
Inflation and independence
1947 provides a cautionary tale about the dangers of prioritizing U.S. debt reduction over sound policies to promote economic growth. Unlike 1947, we now have an independent central bank that is willing and able to constrain inflation, but that is not the only policy choice before us today. As Congress and the president face the fiscal cliff, they should recall the Douglas hearings and promote a policy compromise that prioritizes promoting economic growth more than limiting government debt. When President Eisenhower took office in 1953, he engaged in massive fiscal stimulus coupled with tighter monetary policy, and it led to the most economically productive decade in American history, the 1950s. If we can recreate that kind of policy magic and allow the Fed to resume its usual role of dance chaperone taking away the punch bowl, rather than DJ trying to get the party started, then sustained economic growth will aid in deficit reduction and the economy will benefit in the long term.
Evan A. Schnidman is a Ph.D. candidate at Harvard University studying how politics and finance play a role in central-bank decision making. He is also the founder and primary author of FedPlaybook.com, a central bank forecasting and analysis resource for investors.