“Shortly after October 6, 1979 [US Federal Reserve chair Paul Volcker] met with some managing directors of medium-sized companies. . . . One CEO revealed that he had recently signed a three-year employment contract with annual pay increases of 13 percent – and was happy with the result. Only bitter experiences could eliminate inflationary expectations and behavior. “Credibility” needed to be gained through suffering. That was essentially the Volcker program.” — Robert J. Samuelson,
Will the Federal Reserve abandon its aggressive, contractionary monetary policy once markets begin to capitulate? Many investors hope so. However, given the fundamental conditions, it could be advisable to refrain from such fantasies. The Fed is unlikely to place policy on hold early. This means we should always prepare for economic problems more severe than any we’ve got experienced within the last decade.
To understand why the Fed is unlikely to budge, we must first understand the severity of the threat.
Depression turned on its head
The United States has experienced periods of high inflation that lasted longer than a 12 months only six times since 1800. In all but one case, the first reason was full military mobilization or the immediate consequences of such mobilization. Of course, that was intentional: wars are easier to finance by printing money and devaluing the currency than by raising taxes.
So what was the one glaring exception to this pattern? The great inflation from 1968 to 1982. Defective monetary policy was clearly responsible. A misguided Fed succumbed to pressure from politicians of each parties who preferred reducing unemployment to cost stability.
US inflation rate, 1800 to 2020
The Fed’s flawed philosophy on this era stems from the Phillips curve concept. Economists on the time believed that there was a stable trade-off between inflation and unemployment and that lower unemployment might be achieved in exchange for barely higher inflation. What Phillips Curve supporters failed to grasp, nonetheless, was that while there was a compromise, it was only temporary. When unemployment fell below its natural rate, a brand new baseline for expected inflation was established, and unemployment rates eventually returned to their previous levels. The Fed would loosen monetary policy again if unemployment increased, and inflation would skyrocket every time. In the seek for unsustainably low unemployment, the Fed created a vicious circle: the country suffered from high unemployment and high inflation, or “stagflation.”
This was as painful as a deflationary depression, but was accompanied by a sustained rise in prices reasonably than a decline. This was the basic dynamic underlying the Great Inflation.
Few who lived through the Great Inflation have fond memories of its economic impact. From 1968 to 1982, the United States experienced 4 recessions. High inflation put pressure on real wages: staff had higher salaries but less purchasing power. Home loans and industrial loans became increasingly unaffordable as lenders raised rates of interest to offset higher inflation expectations.
Meanwhile, stock returns have been dismal. Investors demanded higher returns relative to rising rates of interest and the price-to-earnings ratio plummeted. Price instability slowed business investment and operational efficiency and led to sharp declines in productivity. The hopelessness was paying homage to the Great Depression. This is proven by the misery index, which adds the inflation rate and the unemployment rate. During the Great Inflation, the metric was not removed from its level through the Great Depression. An average of 13.6% from 1968 to 1982 in comparison with 16.3% within the Nineteen Thirties.
US Misery Index, 1929 to 2021
The official misery index begins in 1948. The unemployment and inflation data used to calculate the measure before 1948 are based on a distinct methodology. Nevertheless, the overall trend might be in the suitable direction.
Messages from politicians made the situation worse. They refused to query their economic assumptions and as an alternative blamed inflation on exogenous events corresponding to oil embargoes and the Vietnam War. But as these shocks subsided, inflation persevered. A retrospective evaluation of this event concluded that these weren’t significant causal aspects; They only increased inflation marginally. The principal cause was persistent, overly accommodative monetary policy.
Only when Volcker, supported by President Ronald Reagan, began his tireless campaign to scale back the cash supply did the Fed restore its credibility and eventually end the Great Inflation. Of course, Volcker’s campaign was not in vain. The country suffered a terrible recession from 1981 to 1982, when the federal funds rate peaked at 20% in June 1981 and unemployment reached 10.8% in 1982. The country paid a heavy price for 14 years of wasted money. It is just not something that US central bankers will easily forget or readily repeat.
Prevent topsy-turvy depression
The Fed’s current leadership deserves some sympathy for the challenges it has faced for the reason that start of the COVID-19 pandemic. First, In March 2020, the country averted a second Great Depression with the assistance of great fiscal stimulus, and now, just two years later, it must counter a possible second Great Inflation. And stopping the latter in 2022 is just as essential as stopping the previous in 2020, even when the countermeasures are exactly the other. Giving people extra money prevented a return to the Nineteen Thirties; To prevent a return to the Seventies, you might have to take money away.
The Fed is already one step back. Admittedly, it misjudged the persistence of inflation post-COVID-19 late last 12 months. Therefore, more draconian measures could also be required to make up for previous missteps. And time is running out. The longer inflation persists, the more expectations will shift upwards and the upper the prices of reversing the inflation spiral can be.
Future outlook
Make no mistake; The Fed knows why the large inflation happened and the way painful a possible repeat could be. She will do what must be done to stop such a catastrophe.
There isn’t any such thing as absolute security when investing. Humans are fallible and economic aspects are unpredictable. But it could be unwise to bet against the Fed’s honesty on this case. Rather, we should always prepare for a tightening of monetary policy that can proceed until prices stabilize. Such a scenario is difficult to assume with no painful recession and further market declines.
Volcker restored the Fed’s credibility through suffering within the early Nineteen Eighties. The Fed of 2022 knows it must pursue an analogous course today. Although the suffering is inevitable, it’s unattainable to say exactly when or how severe it would be. Indeed, those that would speculate should remember Volcker’s admonition:
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