In October 1979 Federal Reserve chairman Paul Volcker, only two months into the job, stopped in Hamburg en route to the International Monetary Fund meeting in Belgrade. West German chancellor Helmut Schmidt was alarmed about soaring US inflation and wanted to talk things over with Volcker, whom he knew from his years as German finance minister.
“For almost an hour,” Volcker wrote in his memoir Keeping at It, Schmidt harangued us about “waffling American policy makers who had allowed inflation to run amok.” Schmidt said high inflation undermined confidence in the dollar and threatened global stability. “I sat there quietly,” wrote the sobered Fed chief who concluded, “there could be no more persuasive argument for why I had to act.”
US inflation at the time was 11.5% and the 10-year treasury yielded 9.4%. The fiscal deficit was $74 billion, equal to 2.6% of gross domestic product.
Over the next several months Volcker and the Fed curtailed growth in the money supply and pushed interest rates relentlessly higher, above the rate of inflation. The inflation dragon was slain but the cost was an 18-month-long recession in 1981/82.
Fast forward 40 years and a new Fed chairman, Jay Powell, deserves the nation’s gratitude for the quick, decisive central bank response to the onset of the Covid pandemic in early 2020. Powell and his colleagues bolstered confidence by lowering short-term interest rates to near zero and launching a massive bond buying program that injected cash into the economy. Combined with equally decisive fiscal stimulus from the Congress economic calamity was averted.
The medicine worked. The economy not only dodged a pandemic recession but rebounded in 2021, achieving stunning 5% gdp growth.
In December Powell laid the groundwork for a significant shift in policy, which he reaffirmed at his January 26th press conference. With the economy strong and unemployment low the Fed chief is turning his focus to fighting inflation. He admits he was wrong in regarding inflation as transitory and says the Fed will end asset purchases in March. He repeated what he said at his Senate hearing for a second four-year term as chairman, that high inflation poses a threat to long-term employment and growth. Volatile financial markets now realize that several rate hikes are coming, that a cycle of monetary tightening is upon us.
Can the Powell Fed do what Volcker couldn’t, threading the needle bringing inflation down without triggering a big market sell off, or worse a recession?
This is the task facing the U.S. central bank. Interest rates have to rise substantially from being negative in real terms to a point where savers get a positive return on their money. There’s a long distance to travel when the 10-year bond is still yielding less than two percent, multiple percentage points below the rate of inflation.
Much depends on the pandemic. If Omicron is near its peak and another variant doesn’t appear many of the distortions in the economy will disappear. Supply chain disruptions would dissipate. With a moderately slowing economy oil is unlikely to remain at its current seven-year high.
Recent history suggests the Fed will succeed. In 2013 when the mere mention of cutting back asset purchases triggered a taper tantrum—a sharp sell-off in stock prices, that hasn’t occurred this time.
Of course high-flying stock prices have retreated but that’s healthy given their huge runups over the past two years. Of more concern is how fast and by how much interest rates will rise.
The Fed tightening is occurring while the economy is strong and unemployment low. As Powell said January 26, “there are many more job openings than there are unemployed people.” Unlike in the Volcker period inflation has not yet run amok. We haven’t entered a spiral of rising prices.
There’s another strong plus. It appears that President Biden’s three to five trillion dollar build back better stimulus is not going to become law. With inflation high, the economy strong, and the budget deficit at a peacetime high of 13% of gdp, more stimulus isn’t required and indeed could do real damage.
In sum the awakened Powell Fed is likely to win the battle against inflation. Remember the words of the late great market guru Marty Zweig who died in 2013. Zweig counseled investors to never bet against the Fed. His oft-repeated mantra: “don’t fight the Fed.” #