Picture of Christopher A. Hopkins, CFA

Christopher A. Hopkins, CFA

Fed gets aggressive on inflation: why it matters

Last weekend, Federal reserve Chairman Jerome Powell delivered one of the shortest and most consequential addresses from a Fed leader in recent memory, signaling unambiguously the central bank’s commitment to manhandle inflation back down to its 2 percent long term target. Many investors were banking on a pivot toward a less aggressive stance given some early evidence that inflation may have peaked, but Chairman Powell threw the market a curve ball and reiterated the likelihood of short-term pain in pursuit of longer run price stability.

In effect, the Fed intends to manufacture a mild recession and boost unemployment to bring prices down. To understand why such bitter medicine is required, it is important to grasp just how insidious sustained inflation can be and how hard it is to break the fever once it rages.

Broadly defined, inflation is the annualized rate of increase in the prices of goods and services across the overall economy. An alternative view is the decrease in purchasing power of a dollar over time. Most of us have heard Grandpa waxing nostalgic for the old days when pop was a nickel and gas was a quarter a gallon. The good old days.

A healthy economy needs a small amount of annual inflation to support steady output and income growth over time, and in the US the Federal Reserve maintains a target of 2%. Sustained inflation above that rate is ultimately detrimental to the stability of the economy, as is a prolonged decline in prices (known as deflation).

The Government compiles and reports several indices that track inflation on a monthly basis. Most familiar is the Consumer Price Index or CPI that measures the relative price of a collection or basket of finished goods and services purchased by urban consumers. The CPI is often the basis for cost-of-living adjustments to benefit programs like Social Security. The so-called core CPI strips out the more volatile components of food and energy to provide a less noisy metric to evaluate broader trends.

The Fed pays attention to a slightly different index called the PCE or Personal Consumption Expenditure index that is somewhat broader than the CPI. It is this measure of inflation for which the Fed targets the 2% annual increase.

By any of these measures, inflation has been relatively tame for the past 40 years, averaging less than 3% for the entire period and trending below 2% in recent years up to the 2020 Covid pandemic. This sustained period of price stability provided a foundation for the expansion of the US economy over that period, but the victory was hard won, and the lessons of the past were recounted by Chairman Powell in his brief remarks.

The stretch between 1965 and 1982 came to be known as the “Great Inflation.” For the year 1964, inflation was a mere 1%; by 1980 it had reached near 15% thanks in part to a major increase in government spending on the Great Society, two oil shocks from OPEC embargoes, and the deficit

government spending on the Great Society, two oil shocks from OPEC embargoes, and the deficit financing of the Vietnam War. While not known or appreciated at the time, mistakes by the Federal reserve exacerbated the crisis by allowing the money supply to expand rapidly in an effort to reduce unemployment. The policy errors ultimately produced the worst of both worlds: high inflation and high unemployment, a combination that came to be called “stagflation” which did not fit any current economic theory.

What we now know is that the enemy is not a temporary bout of inflation per se, but a sustained increase in consumers’ expectations of inflation in the future, a self-reinforcing cycle that baked inflation into the cake. Labor unions, for example, came to anticipate higher inflation and negotiated cost of living hikes into their 3-year contracts. Auto manufacturers summarily raised car prices to pass along the cost, lenders increased loan interest rates to compensate for the declining value of repayments, and so on creating a systematic structural expectation of progressively higher prices.

In 1979, President Carter appointed economist Paul Volcker to chair the Federal Reserve Board. Volcker understood, building on the work of Milton Friedman, that the central bank had to get tough and stay tough until structural inflationary expectations has been brought to heel. Volcker commenced tightening the money supply and restricting bank reserves to raise interest rates and curtail lending, plunging the US into a severe recession. By 1982, the unemployment rate reached nearly 11%, and the pain was widespread, but the medicine worked. By year end, inflation was back down to 5% and soon trended down toward the 3% level that has prevailed until 2021. Regardless of one’s view of President Carter, his willingness to bite the bullet and turn Volcker loose deserves great credit.

Going into 2021, most Fed officials including Chairman Powell believed the inflationary pressures from the sudden post-Covid surge in demand combined with the related supply chain disruptions would prove to be transitory. However, it became it became increasingly clear that price pressures were gaining steam and there was growing danger of reigniting expectations for sustained inflation in the future, threatening a repeat of the stagflation of the 1970s. Hence the Chairman’s forthright address and warning that the path would not be easy, but the Fed would stay the course.

The treatment for this ailment is unpleasant, but its efficacy is well understood, and the prognosis is excellent.

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