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The Fed Has a New Plan to Avoid Recession: Party Like It’s 1994

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The history of central bank rate hikes appears to support the inevitability of an economic downturn, but there have been rare instances when the Fed has raised interest rates and avoided recession: One example is 1994.—cnn.com, May 16, 2022

Some data

In 1994, the Fed raised the federal funds rate from 3 percent to 5.5 percent in small steps through the year. The inflation rate fell from 3 percent to 2.5 percent, and the unemployment rate fell from 6.6 percent in January to 5.5 percent in December. The natural unemployment rate was 5.5 percent.

In April 2022, the federal funds rate was 0.3 percent, the inflation rate was 6.1 percent, and the unemployment rate was 3.6 percent. The natural unemployment rate was 4.4 percent.

Answer the following questions to check your understanding of the story.

1) How do we know that the expected inflation rate fell in 1994?

We know the expected inflation rate fell in 1994 because the inflation rate fell, the unemployment rate decreased, and _____________ .

Does the short-run Phillips curve illustrate a fall in the inflation rate and a decrease in the unemployment rate as a movement along the curve or a shift of the curve? Under what circumstances does a shift of the curve occur?

During 1994, the inflation rate fell, and the unemployment rate decreased. This can happen only if the short-run Phillips curve shifts downward, which occurs when the expected inflation rate falls, or when the natural unemployment rate decreases. But the natural unemployment rate didn’t change in 1994, so the expected inflation rate must have fallen.

2) With no change in the expected inflation rate or the natural unemployment rate, how will the inflation rate and unemployment rate change as the Fed raises the federal funds rate in 2022?

The inflation rate will ______________ and the unemployment rate will______________.

The Fed raises federal funds rate to combat inflation. With no change in the expected inflation rate or the natural unemployment rate, a movement will occur down along the short-run Phillips curve. What happens to the inflation rate and the unemployment rate?

The Fed raises the federal funds rate to combat inflation. With no change in the expected inflation rate or the natural unemployment rate, a movement will occur down along the short-run Phillips curve as the inflation rate falls and the unemployment rate increases.

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