What the Fed Is Afraid Of
Fed watching and Fed criticism have long been a staple of financial media. You would be shocked at the fortunes made by people with a perpetual hatred of the Fed, armed with little more than a newsletter and a booking agent. When rates are high, the Fed is "behind the curve." When rates are low, the Fed is "hurting savers." They can't win.
If I knew how easy it was to pass this off as "analysis," I would have chosen another line of work.
When it comes to our present situation, a unique moment in history dealing with a war and a (hopefully) post-pandemic economy, Fed policy gets my attention a bit more than usual.
Some of the chatter from Fed officials is how much more to raise rates at the next meeting. Many are in favor of another 75 basis point hike, which seems to me to be a bit of overkill at this moment. We're seeing a lot of deflationary pressures across many sectors, but at the same time, the employment picture looks strong and consumer spending is still solid. People may be complaining about gas prices, but they're still buying full size pick ups and SUVs as fast as the OEMs can build them.
There has been some internal pushback against another 75 bp hike in favor of just 50 bps, which to me, (with my admittedly limited data resources) seems more appropriate. But the thought had crossed my mind that what the Fed was really afraid of was repeating the playbook of the last inflationary episode of the 1970s.
And that turned out to be a prescient call.
For those of us who lived through those times, inflation was a genuine calamity. By those standards, today's price pressures are a mere nuisance by comparison. But Fed policy back then was a frustrating cat and mouse game when it came to keeping inflation down, as this chart from 1979 to 1985 shows.
While the inflation of the 70s captures a lot of the pain (CPI was at 14.8% by the end of Chairman Arthur Burns term in 1978) the Fed response was considered timid, and therefore ineffective. As I recounted in an earlier article:
"But while Nixon was fixing prices, his Federal Reserve Chairman, Arthur Burns, was executing an expansionary monetary policy. Burns was simply unwilling to administer the medicine the economy needed, (some say Nixon threatened him not to) and by doing so, made things worse, for longer. By the end of his term, inflation went to 14.8%. Then President Jimmy Carter appointed G. William Miller. He lasted only a little over a year in the job. Carter replaces him with Paul Volcker. He almost immediately raised the Fed Funds rate and stopped inflation- and the economy- practically dead in it's tracks. The strategy seemed to be very effective, however. Note that after the first round of hikes in 1979, CPI plummets."
And that's where the yo-yo rate policy referenced by Fed Governor Waller comes in. Starting In mid 1979 and through the beginning of 1980, (1) Paul Volcker spikes the Fed Funds rate (blue line) to over 17%. CPI (red line) nosedives on a percentage basis and Volcker relents (2)
Inflation immediately takes off again. so Volcker responds in kind. (3)
CPI responds to the medicine, (4) and Volcker eases again.
CPI jumps for another round, and Volcker slams on the brakes once more. And this time, hard. (5)
The large dose works again. (6)
Another, albeit smaller inflationary episode occurs in 1982 (7) but by this time, it looks like the price pressures that once plagued the economy are at long last, subdued. The inflationary period was long. But note that it took over FIVE YEARS of some radical policy to fix it.
And that's what's behind the hawkishness of many Fed Governors. If they didn't live through it themselves, they spent a whole lot of career time studying this episode and its implications. So no matter what the current situation is, people with long memories are going to want to lean in a more restrictive rate environment.
It's going to be an interesting time. Let's hope they finesse this thing with a good outcome.