It’s easy to end a transitory inflation. It’s hard to end a persistent inflation. That’s why it’s essential that central banks engage in “level targeting”. Level targeting makes all inflation transitory.
When the Korean War broke out in June 1950, the US economy was experiencing a period of mild deflation. By February 1951, the 12-month CPI inflation rate had reached 9.4%. By February 1952, inflation was back down to 2.2%. How did the Fed achieve success so quickly, without triggering a recession in 1952?
The transitory inflation of 1951 was not a supply shock—NGDP rose at an extremely rapid rate. Inflation would not end just because the supply shock went away. There were price controls, but it wasn’t just inflation that declined in 1952—NGDP growth also fell very sharply. So monetary policy did significantly reduce aggregate demand in 1952. (Contrast this with the 1971-74 price controls.)
The key to the Fed’s 1952 success was level targeting. Between 1934 and 1968, the US pegged the price of gold at $35/oz. This provided monetary policy with credibility, keeping long-term interest rates at relatively low levels. As a result, the Fed was able to eliminate the high inflation of 1951 with a relatively small increase in short-term interest rates, as 3-month T-bill yields rose by only about 40 basis points between 1950 and 1952:
(A similar small increase in interest rates eliminated the transitory inflation of 1936-37; although that policy was too contractionary, pushing the economy into a deep slump in 1938.)
As recently as last September, the Fed’s FAIT policy still had some credibility. Markets assumed that the Fed would keep inflation around 2%, on average. Ten year T-bond yields remained around 1.3%. At the time, markets (wrongly) assumed that the Fed would engineer a 1952-style soft landing.
As Fed officials began moving away from their promise to keep average inflation near 2%, long-term bond yields rose sharply. Eliminating inflation will now be much more costly. Interest rates will have to rise more sharply and the economy will slow by more than if the FAIT policy had been maintained.
People often ask me how high the Fed needs to raise rates to control inflation. The answer depends on the policy environment. With a credible level targeting regime, only a tiny rate increase is required. But as we saw in 1981, without policy credibility a dramatic rate increase is required.
Right now the Fed is somewhere in between these two extremes. It has less credibility than in 1951 but more than in 1981. The longer they wait, the higher the price that must be paid.