The unmooring of inflation expectations greatly complicated the process of making monetary policy; in particular, the Fed’s loss of credibility significantly increased the cost of achieving disinflation. The severity of the 1981-82 recession, the worst of the postwar period, clearly illustrates the danger of letting inflation get out of control.
This recession was so exceptionally deep precisely because of the monetary policies of the preceding fifteen years, which had unanchored inflation expectations and squandered the Fed’s credibility. Because inflation and inflation expectations remained stubbornly high when the Fed tightened, the impact of rising interest rates was felt primarily on output and 12 employment rather than on prices, which continued to rise.