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The last time the Fed curbed inflation without crashing the economy, explained

The Federal Reserve is again trying to raise interest rates without causing a painful recession.

A photo illustration of former White House Secretary of Treasury Robert Rubin, left, and the former Federal Reserve Chairman Alan Greenspan.
Christina Animashaun/Vox; Wally McNamee/Corbis via Getty Images
Madeleine Ngo covers economic policy for Vox. She previously worked at the New York Times, the Wall Street Journal, Bloomberg, and the Philadelphia Inquirer.

Inflation is finally starting to slow, boosting hopes that the Federal Reserve can pull off a “soft landing”: raising interest rates and weakening the economy while also avoiding a painful recession.

The Fed lifted rates by half a percentage point on Wednesday, a slight pullback after raising them by three-quarters of a percentage point at its previous four meetings.

Although consumer prices are still much higher than they were a year ago, they’ve started to ease. In November, prices rose 7.1 percent from a year before and 0.1 percent from the prior month, according to a Consumer Price Index report released on Tuesday. That’s slower than the past few months, when prices rose 7.7 percent in October and 8.2 percent in September.

A soft landing is rare. The Fed last pulled one off in 1994, an occasion that some economists call a “perfect” soft landing. Inflation was around 3 percent, and the Fed — which was chaired by Alan Greenspan at the time — was trying to stabilize prices before they shot up. In a series of seven rate hikes beginning in February 1994 and ending in February 1995, policymakers roughly doubled interest rates to 6 percent.

The result was successful. The economy averted a recession, inflation stabilized around 3 percent before drifting down, and unemployment continued to fall for most of the late 1990s. Although economic growth weakened in the first half of 1995, it later rebounded, and a period of strong expansion followed. The Fed later lowered interest rates to 5.25 percent in January 1996 before raising them again to 5.5 percent in March 1997.

How the Fed pulled it off

The 1990s began with a brief recession attributed to a few factors: a spike in oil prices after Iraq’s invasion of Kuwait, the Fed’s attempts to lower inflation, and accumulated debt from the 1980s. But by 1994, the economy was expanding and the labor market was stronger. Economic forecasters worried, though, that inflation would soon rise.

There are several key differences between now and 1994. Most notably, the Fed was trying to stabilize inflation at the time rather than bring it down substantially. Inflation is much higher now than it was in 1994, and policymakers are facing a bigger challenge now.

But there are some lessons to take away from the Fed’s last — and what some economists believe is the only — soft landing. Alan Blinder, who was vice chair of the Federal Reserve’s Board of Governors from June 1994 until January 1996, said the central bank achieved a soft landing at the time with both “luck and skill.”

Blinder, now an economics professor at Princeton University, said policymakers were nervous about inflation shooting higher at the time because the economy was strong. So Greenspan and other members of the Federal Open Market Committee, which sets the federal funds rate, decided to start raising rates for the first time in five years.

The Fed was lucky there were no “serious supply shocks” that rocked the economy at the time — a distinction from now, Blinder said, as the pandemic continues to disrupt the production of goods around the world. The war in Ukraine has also led to a spike in food and energy prices, which tend to be more volatile and difficult for central bank officials to address.

Blinder said the Fed was also successful because officials pulled back their rate hikes “before it was too late.” There was considerable debate among committee members about when to halt rate hikes and what rate would be high enough to slow demand and stabilize inflation, he said, adding that it was a “classic mistake” for central banks to overtighten because the full effects haven’t yet shown up in the economy.

It’s a difficult balancing act for the Fed. Officials risk dramatically slowing the economy and causing a painful spike in unemployment if they raise rates too aggressively. But the Fed also risks doing too little and allowing inflation to become a more permanent fixture of the economy, which Fed Chair Jerome Powell has argued could be harder to address in the future.

Although Fed officials were able to avoid a recession after hiking rates in 1994, Blinder said it wasn’t clear at the time whether they would be able to pull it off. There are always risks that economic models and predictions could have been off or an outside shock could have led to a spike in inflation.

One key difference was that policymakers back then didn’t have one single goal. Now the central bank clearly targets 2 percent annual inflation over time, but that objective was only formally declared in 2012. Blinder said individual FOMC members at the time had varying goals, ranging from inflation running from 0 to 3 percent.

In Blinder’s recently published book, A Monetary and Fiscal History of the United States, 1961–2021, he wrote that he and Janet Yellen, then a Fed governor and now Treasury secretary, were more concerned that the Fed might be overdoing their rate hikes, although neither of them formally dissented. Blinder said the committee was a “pretty hawkish bunch” back then, meaning that many members were more concerned about limiting inflation.

Doves, on the other hand, typically advocate for lower interest rates to stimulate the economy and boost employment. Blinder said he and Yellen were the two most vocal doves on the committee then, although there were a few bank presidents who shared similar views but were less outspoken.

“We were not eager to do more damage to the real economy than we felt we had to,” Blinder said.

Blinder said Greenspan was not extremely vocal about his goals for inflation at the time, but the former Fed chair didn’t want to go overboard, either.

“The secret dove was Alan Greenspan,” Blinder said. “He liked to play the role of the super hawk and he wanted zero inflation, but he didn’t really. He was pretty content with 3 percent inflation.”

Vincent Reinhart, who was chief of the Fed’s banking and money market analysis sector in 1994, said the situation was similar in part because the Fed was fairly aggressive with its rate hikes back then: other than this year, the last time the Fed raised rates by three-quarters of a percentage point was in 1994.

But Reinhart, now the chief economist and macro strategist at Dreyfus and Mellon, also said the 1994 soft landing was different in many ways. The Fed was acting preemptively at the time, whereas now, policymakers are “chasing inflation that has risen.” He also said he expected the Fed to be even more aggressive with its rate hikes to bring down inflation.

“Powell and his colleagues were reacting retroactively to inflation that was 9 percent,” Reinhart said. “The scale of the problem is so much different.”

Achieving a soft landing now is harder, but still possible

A growing number of economists are predicting that the economy will tip into a recession next year. While some economists believe a recession is more likely than not, others say it’s still possible for the Fed to pull off another soft landing this time around.

Reinhart said it was unlikely that the Fed would pull off another soft landing now, and there were many reasons to believe the United States would enter into a recession in the next 12 months. Central banks around the world are raising rates, which has contributed to a slowdown in global growth. The pandemic and the war in Ukraine have also made it more challenging for the Fed to address rising prices and supply constraints, he said. Still, Reinhart said he was expecting a recession would be relatively mild.

Blinder said he believed the Fed could achieve a “soft-ish” landing — or a mild recession next year — for several reasons. He said the current committee appears to be more dovish and doesn’t want to “crash the economy” with its rate hikes. He also said many factors that have pushed inflation higher appear to be dissipating as supply chains clear up and oil prices come down from their peaks.

The unemployment rate, which stands at 3.7 percent, is also near a half-century low and the labor market is still strong, meaning that it has more room to slow, Blinder argued.

He also said the Fed has a better track record of pulling off soft landings than it’s credited for. Out of 11 instances of the Fed fighting inflation over the last 60 years, it achieved a soft landing or came close in six cases, Blinder wrote in a recent essay for the Wall Street Journal. In the other five, he said, the Fed wasn’t trying to achieve a soft landing, since it needed to “hammer the economy over the head” to bring down inflation, or because external events occurred out of the Fed’s control. In the 1970s and early 1980s, for instance, then-Fed Chair Paul Volcker was intent on bringing down double-digit inflation and engineered two recessions. Blinder said Volcker knew the cost would be high to bring down inflation at the time.

And in 1988, the Fed likely would have pulled off a soft landing if it weren’t for the big oil shock that followed after Saddam Hussein’s invasion of Kuwait in August 1990, he said. He also said the Fed achieved a “soft-ish” landing after it started raising rates in 1965, for example. From September 1965 to November 1966, the Fed raised interest rates from about 4 percent to about 5.75 percent, which stabilized inflation around 3 percent for a while. But there is some dispute about that case because inflation later ticked higher and reached 6 percent by 1970.

Still, Blinder noted that the Fed is now trying to bring down already-high inflation, meaning that the central bank would have to “hit the economy a bit harder with interest rates.”

Bill English, a former director of the monetary affairs division at the Fed and an economist at Yale University, said bringing down rising prices this time is also a bigger challenge because the economy has been atypical. Fed officials initially claimed that the surge in prices would be “transitory,” but they’ve been surprised by how stubborn inflation has been.

English said the lagged effects of monetary policy also complicate the Fed’s path to achieving a soft landing, since they typically aren’t seen for about a year. If officials don’t do enough to contain inflation, consumers and businesses could begin to expect higher inflation in the future, which would further fuel higher prices, since workers would likely ask for wage increases and put even more pressure on inflation.

The inflation outlook has improved in recent months, however, as supply problems have eased and some data suggests that rental inflation could slow in the coming months, English said. That means the Fed could potentially slow the economy and increase unemployment without causing a recession, he said.

“It could happen, but it’s tough,” English said.

Joseph Gagnon, a senior fellow at the Peterson Institute for International Economics and former Fed official, said there were “grounds to be more optimistic.” Household savings are still fairly strong, although lower-income households have been burning through that extra money.

“Relatively speaking, households are in good shape,” Gagnon said. “We’re starting from a very low unemployment rate, so some modest rise wouldn’t be too damaging. We’re in a good position.”

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