Sluggish recovery: An unintended consequence of a low inflation policy

Because of the high inflation period that began in the late 1960s (causing President Nixon to impose wage and price controls in August 1971) which eventually escalated to double digit inflation in the early 1980s, the Fed became committed to reducing inflation. The result was reduced inflation, and a deep recession (U.S. unemployment peeked higher than during the 2008 recession). Inflation and inflationary expectations continued to drop. This goal of low inflation continued until it was replaced with a desire to reduce interest rates during the later Greenspan years (clearly the two policies are intertwined). In the paper I show that recessions prior to 1985 had strong “V” like recoveries using a variety of measures (as does the National Bureau of Economic Research (NBER) in evaluating a recession). In contrast, I show that recoveries after 1985 (1991, 2001, and 2008 recessions) were anemic using the same variety of measures, in fact, the recovery from 2008 was stronger using some measures. Although much has been made of the slow recovery since the deep 2008 recession, the slow recovery from the other two recessions went generally unnoticed (recall Clinton’s reminder to his campaign staff in 1992 “It’s the Economy, Stupid”). I develop a model that relates low inflation to the macro-economy using a dynamic aggregate demand and supply model as its starting point. Then using dynamic stochastic general equilibrium (DSGE) estimation, I show that a policy that targets a higher rate of inflation, and correspondingly higher interest rates, results in the V shaped recoveries that we previously observed. Further simulations show that a low inflation and interest rate policy during the recessions prior to 1985, results in much slower recoveries. Finally, I evaluate the cost of a higher inflation policy versus the policies of the last 30 years.