A Look at Fed Tightening Episodes since the 1980s: Part I

With consumer price inflation at a 40-year high in February and with some measures of inflation expectations alarmingly high compared with their pre-pandemic levels, the Federal Open Market Committee (FOMC) voted to raise its federal funds target rate (FFTR) range by 25 basis points to 0.25% to 0.5% at the conclusion of its March 15-16 meeting. (Hereafter, the post will refer to the midpoint of the target range.) According to the FOMC’s Summary of Economic Projections (SEP) that was released immediately following the March meeting, the median FOMC member anticipates that the FFTR will—under “appropriate policy”—need to rise to 2.8% by the end of 2023 and remain there through the end of 2024. At this level, the FFTR would be roughly 275 basis points above its rate before the March increase. However, some FOMC members, such as St. Louis Fed President James Bullard, argue that the FFTR will need to increase by 300 basis points or more.See the March 2022 On the Economy blog “President Bullard Explains His Recent FOMC Dissent.”

As shown in the table below, the March action marks the start of the seventh tightening episode since the 1981-82 recession, which began a period often termed the Great Moderation. For purposes of this blog post, a tightening episode is an initial increase in the FFTR followed by a series of subsequent increases.This blog post is based in part on research by the author for an article titled “A Comparison of Fed ‘Tightening’ Episodes since the 1980s“ that will appear in a forthcoming issue of the International Journal of Central Banking. The table shows that the duration and magnitude of the previous six tightening episodes has varied over time. The episode of the shortest duration, and with the smallest increase in the FFTR, occurred from June 30, 1999, to May 16, 2000, when the FOMC raised the FFTR by 175 basis points. The episode with the largest increase occurred when the FOMC raised the FFTR by 425 basis points over 17 meetings from June 30, 2004, to June 29, 2006. The average tightening action across all six episodes was 293 basis points, which is close to the cumulative projected increase reported in the March 2022 SEP.

Recent stories in the financial press have drawn a connection between the FOMC’s projected FFTR increases and the recent, brief inversion of the Treasury yield curve (also called the term spread) between the 10-year Treasury note and the two-year Treasury note.Based on closing prices, this particular curve inverted on April 1, although the press began to discuss this issue when the curve temporarily inverted during intraday trading on March 29. This post, like the literature, uses closing prices to determine inversions. A yield curve inversion occurs when the yield on a short-term Treasury security exceeds the yield on a long-term Treasury security. Historically, yield curve inversions have been an unusually accurate predictor of recessions—though not the cause of recessions.See David Wheelock’s December 2018 On the Economy blog post, “Can an Inverted Yield Curve Cause a Recession?”

However, not all Treasury yield curves have inverted. While the academic literature has used different yield curve measures, the most common spread tends to be the difference between the 10-year Treasury note and the three-month Treasury bill, and the yield curve for those securities hasn’t inverted. In fact, it has trended in the opposite direction since early March. My post will use this measure of the yield curve.

The table shows that a yield curve inversion occurred in four of the six tightening episodes since the 1980s. Moreover, in three of the episodes—1988-89, 1999-2000 and 2004-06—the FOMC continued to raise the FFTR after the yield curve inverted. The two tightening episodes that did not result in a yield curve inversion were the 1983-84 and 1994-95 episodes. In a recent speech, Federal Reserve Chair Jerome Powell noted that these two episodes were deemed a “successful soft landing”—that is, a tightening episode not followed by an eventual peak in business activity (as indicated in the table’s final column) and subsequent recession.See Chair Jerome H. Powell’s March 2022 speech “Restoring Price Stability” from the 38th Annual Economic Policy Conference National Association for Business Economics in Washington, D.C. In the four cases where a recession followed a tightening episode, the average length of time from the last tightening action until the business cycle peak was about 15 months. In the four cases where a recession followed a tightening episode, the average length of time from the last tightening action until the business cycle peak was about 15 months.

Currently, based on the measure used in this blog post, there is little evidence of a pending inversion of the yield curve. As of April 12, the yield spread between 10-year and three-month Treasury securities measured 198 basis points, up 23 basis points from March 16 and 25 basis points above its long-run average of 173 basis points since January 1983.

Key Takeaway

The FOMC has commenced the seventh tightening episode since the early 1980s. If the FOMC’s economic projections are accurate, the expected increase in the FFTR by the end of 2023 will be close to the average increase registered over the previous six episodes—slightly less than 300 basis points. However, today’s high inflation rate remains the primary concern for monetary policymakers. Considering the possibility that the FOMC may have to tighten more than expectations, some economic commentators are beginning to worry about a recession in 2023. So far, though, the Treasury yield curve examined in this essay—an historically accurate predictor of recessions—is not signaling this outcome.

The second part of this two-part blog series will examine the behavior of key interest rate-sensitive economic variables during these tightening episodes.

Notes and References

1. See the March 2022 On the Economy blog “President Bullard Explains His Recent FOMC Dissent.”
2. This blog post is based in part on research by the author for an article titled “A Comparison of Fed ‘Tightening’ Episodes since the 1980s“ that will appear in a forthcoming issue of the International Journal of Central Banking.
3. Based on closing prices, this particular curve inverted on April 1, although the press began to discuss this issue when the curve temporarily inverted during intraday trading on March 29. This post, like the literature, uses closing prices to determine inversions.
4. See David Wheelock’s December 2018 On the Economy blog post, “Can an Inverted Yield Curve Cause a Recession?”
5. See Chair Jerome H. Powell’s March 2022 speech “Restoring Price Stability” from the 38th Annual Economic Policy Conference National Association for Business Economics in Washington, D.C.