Summary:
With the end of World War II, the massive expansion of defense spending came to a halt, and the money supply financing it quickly stabilized. However, the real money supply declined further with the transitory inflationary upswing of 1946–47, which fueled deflationary expectations, passively pushing up real interest rates and triggering the 1949 recession. We compare the Fed’s current stance to this historical episode, concluding that the ongoing tightening is already sufficient to normalize monetary conditions to prepandemic trends. This article also discusses how fiscal policy might affect "neutral" interest rates in this context.
Key findings:
- After World War II, the US economy faced a sharp but temporary rise in inflation. Subsequent actions by the Federal Reserve led to an excessive tightening of financial conditions. This was a decisive factor in the ensuing recession of 1949.
- The real money supply has now returned to prepandemic trends, potentially raising concerns of further tightening. In this context, increasing policy rates might fuel disinflationary expectations, passively raising real interest rates further.
- This Policy Hub article also highlights the important interactions between fiscal and monetary policy. Government deficits during World War II quickly turned into surpluses. Deficits are now expected to continue to rise. Once the Fed begins to normalize policy, the new level of neutral interest rates might be higher than before the pandemic.
Center Affiliation: Center for Quantitative Economic Research
JEL classification: E6, N12
Key words: Money aggregates, inflation, World War II, neutral interest rates, fiscal policy
https://doi.org/10.29338/ph2023-8