Did the Federal Reserve cause the recession?

SYNOPSIS: Discussion on whether the 1991 recession was the FED's fault

Missing The Economic Signals. Even if the U.S. economy begins to recover soon, the current recession will leave a lasting legacy in economic policy making. The downturn has undermined public confidence in the Federal Reserve Board because the Fed missed the slump's early warning signs. A weaker Fed will now find it harder to resist political pressures to keep interest rates low and growth high. Lower rates could exacerbate price increases, at a time when the latest statistics already show that inflation, excluding food and energy prices, is running at a surprisingly high 5.6 percent annual rate.

The Fed's recent bad press reverses a decade of growing prestige. At the end of the 1970s, in the dying days of the Carter administration, the Federal Reserve was at a low point, blamed by monetarists and conservatives for double-digit inflation. During the 1980s, however, the Fed achieved striking success. Under the leadership of Fed Chairman Paul Volcker, the central bank instituted a policy of tight money that brought an impressive, although costly, victory over inflation. Faced in 1982 with a debilitating recession, Chairman Volcker then reversed course and engineered a rapid and sustained economic recovery. Volcker's successor, Alan Greenspan, successfully slowed that recovery down as the economy approached full employment, without provoking a recession.

Except for a brief period in the 1980s, the Fed has tried to ''fine-tune" the U.S. economy: lowering interest rates when the economy seemed to be slipping, raising them when it seemed to be overheating. But monetarists argued that the Fed's attempts at fine-tuning actually made the economy less -- not more -- stable. They wanted the Fed to establish fixed, pre-announced rates of growth for the nation's money supply.

The Importance of Money Supply. By the time Paul Volcker took over the Fed in 1979, monetarist ideas were in the ascendant, and the central bank announced that it would set monetary targets rather than adjusting interest rates. There followed three years in which money supply grew at a fairly steady rate but in which real GNP oscillated wildly. As a result, the Fed returned to its normal policy of raising and lowering interest rates.

After 1982, money growth rates were erratic, soaring when the Fed thought the economy was too weak, plunging when it thought it was too strong. Nonetheless, the U.S. economy experienced its steadiest growth since the 1960s. But at the end of the 1980s, a triumphant decade, the Fed's willingness to let money growth fluctuate resulted in a serious mistake.

In 1989, the few economists who still looked at the money supply sounded warnings of a recession. Although a key measure of money-supply growth had fallen off sharply, the Fed did not regard the numbers as significant; the central bank was more concerned about taming inflation rather than recession. Money growth may have been a poor predictor of the economy's future during the 1980s, but this time it correctly called a recession that few at the Fed saw coming.

Resisting Political Pressures. The Fed's misjudgment will not result in a major disaster, since the economy will turn around by year's end. The lasting consequence of the 1990-91 recession, however, will be a shift in the balance of power within the U.S. economic-policy establishment. Political scientists who study international inflation rates find that the single most important determinant is the degree of independence of the central bank. In the United States, every administration since Herbert Hoover's has complained that Fed policy is too restrictive, especially in election years. The essential basis of America's relatively good inflation-fighting performance has been the Fed's ability to resist those pressures. The Fed's independence, in turn, depends on a reputation for overwhelming competence. The events of the last few quarters, when the Fed may have been asleep at the switch, have undermined that reputation.

Managing money

The Fed kept money growing at a constant rate until the 1981-82 recession, when it switched to interest rate targets

Money supply, percentage change

1979 6.8 pct.

1980 6.8 pct.

1981 6.8 pct.

1982 8.7 pct.

1983 9.9 pct.

1984 5.9 pct.

1985 12.3 pct.

1986 16.8 pct.

1987 3.5 pct.

1988 4.9 pct.

1989 0.9 pct.

1990 4.0 pct.

Pursuing prosperity

The Fed pulled the economy out of recession in 1982 by slashing interest rates

Real GNP, percentage change

1979 0.6 pct.

1980 -0.1 pct.

1981 0.6 pct.

1982 -1.9 pct.

1983 6.5 pct.

1984 5.1 pct.

1985 3.6 pct.

1986 1.9 pct.

1987 5.0 pct.

1988 3.5 pct.

1989 1.8 pct.

1990 0.4 pct.

Slowing supply

Money supply fell in early 1989, signaling trouble. But the Fed paid little attention and recession ensued

Money supply, annualized percentage change


J -0.6 pct.

F -0.5 pct.

M -1.5 pct.

A -5.2 pct.

M -6.9 pct.

J -3.9 pct.

J 7.7 pct.

A 0.9 pct.

S 2.9 pct.

O 9.4 pct.

N 1.5 pct.

D 7.1 pct.


J 2.7 pct.

F 8.6 pct.

M 5.4 pct.

A 4.5 pct.

M -0.3 pct.

J 5.9 pct.

J -1.2 pct.

A 8.6 pct.

S 7.8 pct.

O -0.9 pct.

N 3.1 pct.

D 3.1 pct.


J 1.9 pct.

Note: Money supply reflects M1, which is the sum of currency, travelers checks and other checkable deposits.

Originally published in The New York Times, 4.1.91