Fighting the Last Inflation War

CAMBRIDGE – In 1955, then-US Federal Reserve Chair William McChesney Martin famously said that the Fed’s job was to take away the punch bowl “just when the party was really warming up,” rather than waiting until the revelers were drunk and raucous. Decades later, in the aftermath of the 1970s inflation, it became an article of faith among monetary policymakers that they should not wait until elevated inflation showed its face before reining in an overheating economy. Today, with inflation surging, they are developing a renewed appreciation for the punch-bowl metaphor.

During the decade that followed the 2008 global financial crisis, adherence to this time-honored practice arguably led some central banks to pursue unnecessarily tight monetary policies. In retrospect, they sometimes overestimated the danger of inflation.

In 2021, central bankers once again “fought the last war,” but this time by underestimating the danger of inflation as economic recovery began to run into capacity constraints. By the end of 2021, the US unemployment rate had dipped below 4%, and inflation, at 7%, had hit a 40-year high. The Fed, having earlier taken the optimistic view that any inflation would be transitory, must now play catch-up.

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