What the Korean War Era Reveals About the Fed’s Inflation Dilemma

The U.S. Federal Reserve is facing a complex challenge: With the annual inflation rate surpassing 8 percent—well above the Fed’s stated goal of 2 percent—the central bank is attempting to bring inflation down by raising interest rates aggressively and gradually reducing its holdings of government and mortgage-backed securities. However, this already challenging task is being made more daunting by forces outside the Fed’s control. These include global supply chain snarls from the postpandemic reopening; oil price increases due to Russia’s invasion of Ukraine and other geopolitical tensions; rising concerns of recession among many U.S. trading partners; and uncertainties caused by continuing COVID-19 measures, especially in China.

Though many economists have looked to the “Great Inflation” of 1965–1981 to shed light on the current situation, perhaps a better analogy is the period spanning the aftermath of World War II and the duration of the Korean War, from 1947 to 1954. This era, like today’s, was characterized by pent-up consumer demand, war-induced uncertainty, and a Fed policy moving from offsetting a national crisis to offsetting inflation. The Fed’s tightening monetary policy and the resulting sharp but short recession can shed light on what choices await U.S. policymakers now.

What happened after World War II?

The World War II era saw prolonged low interest rates and growing balance sheets, similar to the Fed’s policy over this past decade. To support the government’s war effort, the Fed committed to low interest rates; it set a peg of 0.38 percent on short-term Treasury bills and capped the rate on longer-term Treasury bonds at 2.5 percent. This allowed the government to borrow more cheaply than otherwise. But the policy meant that the Fed committed to purchasing Treasury bills and bonds that the private market did not; as a result, the bank effectively gave up control of both the size of its balance sheet and the money supply. The potential for inflation was contained through an aggressive program of wage and price controls.

Although many economists feared that the United States would return to depression after the war, with the end of wage and price controls inflation proved to be the greater threat. By 1947, consumer price inflation (CPI) had jumped to 17.6 percent, reflecting pent-up consumer demand from stringent war rationing, the economy’s inability to quickly switch manufacturing production from a wartime footing to consumer goods, and ample liquidity from an easy monetary policy and expanded monetary base.   

These dynamics worsened with the 1950 U.S. entry into the Korean War; by the following year, inflation reached 21 percent. Some of the jump in prices was attributable to consumers moving up their purchasing to avoid a feared absence of consumer goods like that experienced during World War II.

How does it compare to today’s conditions?

Americans are experiencing many of these same conditions today. During the pandemic, the Fed has expanded its balance sheet and kept interest rates at rock bottom to support the national goal of recovering from economic shock, just as the Fed used these policies during World War II in the service of a broader national interest. In addition, today’s inflation is partially due to pent-up consumer demand for both goods and services after the lifting of COVID-19 lockdowns—mirroring the resurgence of demand after World War II. In both cases, the dramatic increase in demand has strained supply chains.

During the Korean War, as in World War II, Washington was confronted with the challenge of managing inflation while also funding a war effort. This led to a showdown between the Harry S. Truman administration and the Federal Reserve board. Truman pressured the Fed to maintain the World War II rate peg, but by 1951, the bank (eager to focus on reducing inflation) was reluctant. It had lost its appetite to fund government expenditures through low interest rates on government debt and using its own balance sheet to purchase that debt. It also had little interest in another effort to suppress inflation through a wage and price control bureaucracy.

This tension was resolved in March 1951 when President Truman’s Treasury Department agreed that the Fed would no longer be expected to monetize public debt. Known as the Treasury-Federal Reserve Accord, this informal deal set the precedent for the Fed’s independence from political pressure.

What lessons can be learned from the Fed’s approach back then?

With this newfound independence, the Fed began to directly tackle inflation by tightening monetary policy: the interest rate on short-term Treasury bills more than doubled to well over 2 percent by 1953. This and other related measures resulted, as expected, in rising interest costs in the banking system and a decrease in lending.

In consequence, the economy experienced a short but sharp recession from July 1953 through May 1954. It was characterized by a rapid drop in growth followed by a quick recovery, known as a V-shaped recovery. Gross domestic product (GDP) growth dropped from 6.8 percent in the second quarter of 1953 to -2.4 percent a year later, while unemployment rose from 2.5 percent to 6.1 percent (before falling again). By the end of 1954, growth had recovered to 2.7 percent. However, the effect on inflation took longer to register; it finally settled at 0.4 percent in the second half of 1955.

With the Fed currently advertising the sharpest rate increases in over a decade, debate now centers on whether the U.S. economy will suffer a similar recession to bring inflation down or if it will instead experience a “soft landing” that avoids negative growth. Fed Chair Jerome Powell has recognized that, though the Fed has a plausible path to a soft landing, avoiding a recession will be difficult and depends in part on factors outside the bank’s control, such as the repercussions of the ongoing war in Ukraine and China’s continued COVID-19 lockdowns. The experience of the Korean War shows that the Fed has the tools to bring inflation under control, even when it is caused by dramatic shifts in demand, but that doing so is not painless. Powell has clearly stated that under the current circumstances, the Fed is willing to tighten policy sufficiently to achieve its goal, but he and his colleagues have indicated that households and businesses should expect some economic pain.  

There are some signs that this message is being received. In a recent poll, 60 percent of U.S. CEOs surveyed said that they expect the Fed to reduce inflation but that the country will likely experience a short recession in the process, what they dubbed a “reverse soft landing.” Soft landing or not, the experience of the Korean War is instructive in navigating today’s inflation troubles.