“Our monetary policy considerations and decisions build on what we have learned about inflation dynamics from both the high and volatile inflation of the 1970s and 1980s and the low and stable inflation of the last quarter century. These lessons will guide us as we use our tools to reduce inflation. . . . We will continue until we are sure the job is done.” — Jerome Powell, August 26, 2022
In “The Eye of the Storm: The Fed, Inflation, and the Ides of October,” I advisable that investors temper their enthusiasm in response to a powerful stock market rally and never underestimate the Federal Reserve’s determination to combat inflation. On August 26, 2022, Fed Chairman Jerome Powell spoke on the annual Jackson Hole Economic Symposium. His powerful language and deliberate references to the teachings of history dashed any hope that the Fed would back away from its tightening strategy. The stock markets reacted with sharp declines.
Fed leadership has struggled over the past nine months to persuade markets that the dovish stance of the past 40 years is not any longer valid. What explains the communication challenge? Many investors simply don’t understand that this can be a rare and dangerous inflation event. The Inflation from 1919 to 1920 that followed World War I and the Great Flu is essentially the most relevant parallel. While such major crises often lead to temporarily high inflation, the Fed must still act aggressively to contain it. If this doesn’t occur, the temporary inflation could turn right into a repeat of the nice inflation of the Nineteen Seventies and early Eighties.
In his speech, Powell highlighted three distinct lessons from financial history that designate the Fed’s approach. By basing the speech on these lessons, he demonstrated that the Fed recognizes the grave danger if inflation continues at today’s elevated levels, that it accepts its unique responsibility to eliminate that risk, and that it’s committed to: the mistakes of their predecessors, whatever the situation, to avoid the short-term pain that may likely result.
1. “The first lesson is that central banks can and should take responsibility for low and stable inflation.”
In the Fed’s 108-year history, the Great Inflation is probably the most serious mistakes – surpassed only by the Great Depression. The flawed monetary policy of this era resulted partly from the final belief that the Fed had an obligation to synchronize monetary and monetary policy. When successive U.S. presidents pursued overly expansionary fiscal policies, corresponding to the Great Society and the Vietnam conflict, Fed leadership was reluctant to offset these with contractionary monetary policy. In 1965, after the Fed pushed for higher rates of interest (or spending cuts), President Lyndon Johnson reportedly pinned Fed Chairman William McChesney Martin Jr. against a wall at his Texas ranch and shouted: “Martin, my boys are dying in Vietnam and also you won’t print the cash I would like.” When President Richard Nixon was asked whether he respected the independence of Fed Chairman Arthur F. Burns, he replied: “I respect his independence. However, I hope that regardless he will come to the conclusion that he should follow my views.” It was difficult for the Fed to withstand such coercion.
But Powell has now made clear that central banks are taking responsibility for low and stable inflation, signaling that the Fed will resist any potential political pressure.
2. “The second lesson is that public expectations about future inflation can play an important role in determining the path of inflation over time.”
Powell is aware of the big risk that long-term high inflation poses to the US economy. The Fed’s experience through the Great Inflation is instructive. Under Martin, the Fed had the power to curb inflation within the late Sixties. There was no motion, and its inaction didn’t go unnoticed: market participants began to factor higher inflation expectations into their future plans. Once higher inflation took hold within the economy, it became much harder to dismantle. In fact, Fed Chairman Paul Volcker even had to lift rates of interest to twenty% in 1981. History shows that bringing down inflation requires far more aggressive and sustained monetary tightening. It is subsequently crucial to stop higher inflation expectations from arising in the primary place. Powell’s statement shows that the Fed is aware of this risk and recognizes that point is running out.
3. “Which brings me to the third lesson: We must keep going until the job is done.”
“Keep at it” commemorates Paul Volcker, the Fed chairman who triumphed over the longest inflationary crisis within the country’s history. This note shows that Powell understands the intense consequences of the Fed’s half-hearted efforts to tighten monetary policy under Martin and Burns. The truth is that Fed leadership within the Sixties and Nineteen Seventies knew that inflation was harmful; They were simply unable (or unwilling) to cover the fee of termination. Every time they tightened monetary policy, they reversed course prematurely in response to rising unemployment. The public accurately interpreted the Fed’s lack of resolve as an indication that prime inflation would proceed. When Volcker announced a brand new strategy in October 1979, it took several years of labor to persuade the general public that he was serious.
Powell’s recognition that the Fed must “stay tuned until the job is done” sends a transparent signal that a possible recession or rise in unemployment is not going to deter the Fed from further tightening policy. The Fed’s foremost goal is to scale back inflation to its 2% goal. An economic recession and job losses are, in Powell’s words, “the unfortunate cost of reducing inflation.” However, these costs are price it because “a failure to restore price stability would mean far greater pain.” Anyone who remembers the stagflation years of the Nineteen Seventies can attest that we’ll someday be thankful for the Fed’s determination.
Future outlook
Powell’s statement in Jackson Hole reiterated that Fed leadership understands why the large inflation happened and the way painful it is going to be if it happens again. She also reaffirmed the Fed’s independence and its commitment to do whatever it takes to stop a repeat of inflation just like the Nineteen Seventies within the United States.
Anyone who doubts the Fed’s resolve should perhaps reconsider their thesis. The Fed has shown its strength in Jackson Hole, and a powerful one at that. Investors could be clever to arrange for more aggressive monetary tightening until inflation is worn out. This will likely mean more economic problems. Of course, a very powerful lesson from the Great Inflation over 40 years ago is that the pain is definitely worth the long-term gain.
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Photo credit: ©Getty Images/Win McNamee/Staff
