As the world, led by central banks, walks this treacherous path of balancing stable prices with economic growth (or at the minimum avoiding a recession), there have been comparisons galore to past events to try and draw parallels and derive conclusions based on insights from those past episodes.
Arguably, the one episode being talked about the most is Volcker’s conquest of inflation in the 1980s. The entire story that actually spans across 26 years starting 1964 to 1990 can rather insufficiently be summarised into a few sentences as follows – Massive fiscal spending in the US was unfortunately accompanied by a short sighted, unduly loose monetary policy for most of the late sixties and the seventies which led to entrenched higher inflation expectations. We all know that Paul Volcker then increased rates as high as 20% to tame the inflation beast. It was only after rates were taken as high as 20% and more importantly after Volcker kept them “higher for longer” and did not succumb to pressure to lower them in the face of a deteriorating economy and ongoing recession, that the ghost of inflation was well and truly exorcised. Participants, “well informed” of this episode also know that this taming of inflation was not as clean and concise as the above statement makes it to be. Monetary Policy had a lot of “stops and starts” and inflation went up and down and back up again before it was finally conquered and truly anchored at a lower level. That experience forms the basis of their assertion that Chairman Powell, who unarguably has channelled his inner Volcker in the past few months, will not repeat the same mistake of the early eighties and will take rates higher and keep them higher for much longer than what is being currently priced in the markets.
However, this view does not fully take into consideration 2 aspects.
- It is only in hindsight when one knows that inflation has peaked. Every ”stop” and “start” that the Fed undertook during Volcker’s time must have been based on the expectation that inflation has peaked or at the minimum, the belief that the risks to the economy (i.e. the severity of the oncoming recession) outweigh the risks of increase in inflation or inflation expectations
- It is so much easier for both – those who hold this view as well as the FOMC, to be singularly focused on taming inflation when the unemployment rate is 3.5% and initial jobless claims are below 200K. It is a whole different ballgame when the recession turns into a here-and-now situation instead of an oncoming one.
As an illustrative example, lets live through the year 1980 once more through the paragraphs below…..
Backdrop
- Paul Volcker became the Chairman of the Federal Reserve on 6th August 1979 under the Jimmy Carter administration and continued in that job till Mr Alan Greenspan took over in 1987.
- Similar to the 2022 Russia-Ukraine invasion impact on energy dynamics, the seventies witnessed 2 oil shocks – the 1973 Yom Kippur war and the 1979 Iranian revolution.
- But the real major cause of the inflationary decade began long ago in President Lyndon B Johnson’s “Guns and Butter” policies – large fiscal spending on the Vietnam war effort and the spending on the Great Society programs.
- To some extent similar to 2021, the then Fed played a supporting role to the fiscal largesse by keeping monetary policy accommodative for a prolonged period of time.
- Add to this, the Congress taking the US off the gold standard and President Nixon’s suspension of the gold convertibility contributed to a depreciating dollar only exacerbating inflationary strains in the US.
Against this backdrop, on Oct 6th 1979 – a momentous day in the history of monetary policy making – Volcker called for an unscheduled meeting on a Saturday and announced to the markets and the world that he would be waging a firm war against inflation and the tools in this war would be radically altered – from interest rates to controlling money supply in the economy.
Tightening measures in the spring of 1980
In mid-March 1980 President Carter announced a broad program intended to tame inflation. As a part of this program, the Fed undertook the following:
- Voluntary program to restrain the growth of credit by financial institutions
- A 15% deposit requirement on increases in unsecured consumer credit and assets of MMFs
- Increase in the marginal reserve requirements on banks managed liabilities
- Imposition of a 3% surcharge on the discount window borrowing by frequent large bank borrowers
Interest rates climbed higher in response to the monetary tightening and by early April the effective Fed Funds Rate had reached a high of 19.39%. Three month treasury bill rates in regular auctions recorded a high of 16.53% and long term treasury bonds rose to a high of 12.85% in February.
Effects of Monetary Tightening in early 1980
During April and May there was increasing evidence of a weakening US economy.
Real Personal Consumer Expenditures fell sharply in Q2 1980.
On a side note, by way of a simple comparison, real PCE has hardly fallen currently in 2022. In fact, it has been a surprisingly resilient US consumer that has really been holding up the mantle of GDP growth.
Anyways, back to the topic of 1980. The Personal Savings Rate increased from approx. 5% in late 1979 to about 11% by the second quarter of 1980.
GDP fell substantially in Q2 of 1980 and …
— the unemployment rate climbed much higher as well.
Minutes of the early summer meetings of the Fed show increasing concern about the faltering economy. Below is a sample of what the FOMC was discussing in mid 1980 –
“Recent data indicate a substantially sharper economic contraction during the second quarter than had been projected previously, with real gross national product apparently registering its second largest decline in the post war era. All major components of domestic final demand have exhibited consideration weakness in recent months, resulting in sizeable cutbacks in employment and production. Price increases have also eased, and this is associated importantly with developments in the energy sector…..”
FOMC Meeting Minutes mid 1980
It is not difficult to visualize a similar discussion in a FOMC meeting not too distant into the future.
In any case, in response to the weakening economic developments, the Fed loosened the purse strings a bit in the summer of 1980.
Loosening in the summer / autumn of 1980
- In early May 1980, the Fed began to phase out the credit restraint measures put in only months back. It first eliminated the surcharge on the discount window borrowing.
- Later in May, the Fed cut the special deposit requirements and marginal reserve requirements into half.
- Finally in July 1980, the Fed announced that the remaining provisions of the program would also be phased out.
The effective Fed funds Rate which had peaked earlier in the year rapidly declined to as low at 8.68% by the end of July. 3-month T Bill rates reached a low of 6.37% and long term treasury bond yields fell to 9.49% in mid-June.
The swift recovery of economic output by 4Q 1980 and along with it the re-emergence of inflation was almost as fast as the economy’s deterioration in the 2Q 1980.
Re-emergence of inflation in late 1980
In the 2nd half of 1980 and more specifically in the 4th quarter of 1980 leading into 1981, the economy rebounded sharply, monetary aggregates accelerated significantly and demand for credit also saw a sharp upturn.
We all know how this story finally ended. By the end of the decade inflation was well and truly subdued and it would remain so for the next 3 decades before an unknown virus upended economic, monetary and social behaviours that had become second nature to all of us by then.
I wholeheartedly admit that the above is a very simplistic representation of the chronological events of the late seventies and early eighties and it completes omits multiple other important considerations of that time like fiscal policy considerations during that time, the Humphrey Hawkins Act, changes in the CPI calculation methodology, labour reform, political considerations in a presidential election year, etc which exerted various push and pull forces on monetary policy and the final goals of employment and stable prices. But the idea behind the article is to once again drive home the 2 points.
- It is only in hindsight when one knows that inflation has peaked. Every ”stop” and “start” that the Fed undertook during Volcker’s time must have been based on the expectation that inflation has peaked or at the minimum, the belief that the risks to the economy (i.e. the severity of the oncoming recession) outweigh the risks of increase in inflation or inflation expectations
- It is so much easier for both – those who hold this view as well as the FOMC, to be singularly focused on taming inflation when the unemployment rate is 3.5% and initial jobless claims are below 200K. It is a whole different ballgame when the recession turns into a present situation instead of an oncoming one.
While there can be a lot more downside from here on, the fact is that today the treasury market, equity market and housing market are all close to being broken.
Lastly, I am not making any predictions about a Fed pivot since that predictions are only a fool’s errand. But the current volatility does provide an excellent opportunity for investors to position their portfolio. The next few months are bound to be a rough ride as monetary policy continues to tighten and supply side problems continue to be countered with the Fed’s rather blunt tools focused on demand side adjustments. Long term investors will do well over the long run so long as you have the ability and will to stomach the interim volatility. But more interestingly, short term trading opportunities will present themselves as well. Of course, you can lose money if you get the direction wrong. But there are good profits in store for those who are brave and get it right.
Disclaimer and Disclosure: Not meant to be investing advice ! Do your own research! I have selectively been buying long treasury bonds of late for a buy and hold portfolio and will initiate new positions in short term treasury securities shortly as well.
