The Fed and the 1994 Precedent – Avoiding Recession in America Is Proving Increasingly Illusory.
Unlike 1994, the Fed probably reacted too late in 2022.
The current economic crisis is not the first, far from it, and each time in the past the Fed was forced to play the balancing act when America was on the verge of recession. The Fed managed to keep its balance in 1965, 1984, and 1994, negotiating a “soft landing” each time. This is logically the Fed's objective in 2022, and Jerome Powell intends to draw inspiration from the 1994 case. But the general situation has changed.
The Federal Reserve is doing everything in its power to counteract the effects of inflation, at the risk of sacrificing American growth: at the beginning of May 2022, its chairman, Jerome Powell, announced a 50 basis point increase in interest rates, the largest increase in over two decades.
And Powell also indicated that he would not hesitate to do it again. An announcement that triggered a bloodbath on Wall Street. But within the Fed, it is believed that there is still hope to avoid seeing the economy fall into recession, provided that the recipes of the past are followed.
The precedent of 1994 with the seven increases decided
In the 12 months following February 1994, the Fed, under the leadership of former Chairman Alan Greenspan, nearly doubled interest rates to 6% in just seven hikes, including two 50 basis point hikes and one 75 basis point hike:
And it had managed to hold the line despite the most pessimistic predictions.
“I believe the historic record gives reason for optimism: soft landings, or at least soft landings, have been relatively common,” Powell said in a March 2022 speech.
But this is not the 1990s, and the Fed will have to deal with a very different context: Greenspan proactively raised rates when the economy was still booming and wanted to get ahead of the inevitable inflation. Powell raised rates only after inflation had reached levels not seen in decades.
The Fed may be too far behind to be able to reduce inflation without inflicting economic hardship on Americans. In 1994, the baby boomers were at the peak of their careers, many new technologies were being introduced into the workplace, and immigration was high in the United States. All of this led to a huge workforce and productivity rates that kept unemployment low, even as interest rates rose.
By 2022, boomers are retiring in droves and the proportion of the available workforce that is truly active is at an all-time low.
In 1994, the North American Free Trade Agreement (NAFTA) had just been adopted and the Berlin Wall had fallen five years earlier. The world was entering a period of relative stability, which increased the availability of imports and reduced the cost of goods. This was very different from our situation, which was undermined by the consequences of the pandemic and the war in Ukraine, in particular prohibitive freight costs and lagging production lines.
1994 represents an exceptional situation, not the norm
“On closer inspection, the Greenspan Fed was given a considerable opportunity, which the current Fed is unlikely to have in 2022,” wrote Carl Tannenbaum, chief economist at Northern Trust, in a research note. “This is not to say that a soft landing is impossible this time around. But the degree of difficulty is much higher than it was 28 years ago”.
Carl Tannenbaum's observation can be qualified, however: if the emergency landing was particularly successful in 1994, the Fed has other landings to its credit where it was able to limit the damage. Exactly 11 since 1965, 7 of which were resolved with a drop in economic output of less than 1%. Crumpling up the sheet metal but saving the passengers is perhaps the best we can expect in the current situation for the American economy.