“Those who cannot remember the past are condemned to repeat it.” – George Santayana
Another surprisingly hot jobs report last week had investors fretting again over further interest rate hikes from the Federal Reserve. The level of interest rates and the magnitude of their movement has a direct impact on the real economy and is also a critical determinant of asset prices. High-flying tech stocks tanked last year as the central bank hiked rates, and then surged early in 2023 on the misguided hope of rate cuts later this year despite serial warnings to the contrary by Fed Chairman Jerome Powell.
Chairman Powell has consistently asserted that monetary policy would remain restrictive until inflation is beaten back down to the 2% target annual rate, the attainment of which is still some months away. Criticizing the Chairman’s resolve and betting on a premature surrender to political and market pressure has been a popular parlor game. But there is good reason to believe the Fed will stay the course: hard-won experience from the intractable and destructive economic malaise of the 1970s known as the “Great Inflation”. This is a fight the central bank cannot afford to lose.
In 1964, unemployment stood at 5% and inflation was a quiescent 1% as America’s involvement in Vietnam accelerated. President Johnson’s refusal to raise taxes to fund the expanded war effort combined with his ambitious Great Society social policy initiatives led to increasing deficits that were financed with the assistance of an accommodative Federal Reserve that held down rates to minimize the political impact. At this point, there was no coherent and developed theory of monetary policy and in any event the Chairman, William McChesney Martin, often remarked proudly that he was not an economist. His successor, Arthur Burns, was an economist of some renown and recognized the risks of easy money but succumbed to pressure from his friend Richard Nixon to avoid roiling the political waters with interest rate hikes ahead of the 1972 election.
More importantly, however, was the reliance on what was believed to be a reliable economic relationship that proved ephemeral in the 1970s: the tradeoff between inflation and unemployment.
A British economist, A. W. Phillips, had propounded an inverse relationship between wage inflation and unemployment that was eventually extended to include general price inflation. The Phillips Curve was a downward sloping graph that showed unemployment rises as inflation falls. The lesson for policymakers was that they could effectively purchase lower unemployment by allowing inflation to increase, a tradeoff that politicians and voters were more than happy to embrace.
Some dissent was voiced by monetary economists Milton Friedman and Edmund Phelps, who warned that the enticingly precise Phillips Curve had a fatal flaw. They suggested that businesses and consumers would soon catch on and learn to anticipate the resultant inflation from pro-employment policy and build the additional price pressure into their expectations by altering their behavior. By the mid-1970s, the jig was up and expectations for higher future inflation became embedded, a phenomenon economists called structural inflation. Everyone expected prices to be higher next year and therefore they included permanent inflation in their calculus. The entire Phillips curve shifted upwards, accommodating ever higher inflation and unemployment simultaneously.
This coexistence of rising prices and high unemployment was dubbed “stagflation”: economic stagnation combined with soaring inflation at the same time, and it dominated the period of the 1970s. Meanwhile, just as the Phillips Curve lost its magic, the US was buffeted by OPEC oil embargoes in 1973 and 1979 that exacerbated the price spiral. A 1964 Gallup poll found that only 1 in 8 Americans saw inflation as the biggest problem facing the US. By 1974 inflation had surged to 12% even as unemployment rose above 7%, and everyone was cranky; 70% of Americans now viewed inflation as public enemy number one.
Presidents Nixon, Ford and finally Jimmy Carter wrestled with various tactics to beat back inflation, from wage and price controls to moral suasion. But as Milton Friedman had preached, inflation is largely a monetary phenomenon (related to the supply and cost of money) and required a monetary fix. Enter the dragon slayer, Paul Volcker.
President Carter appointed the New York economist to chair the Federal Reserve, and Volcker prescribed bitter medicine. The 6’ 7” cigar chomping Chairman sharply contracted the money supply, a move that caused interest rates to double and sent the US economy into recession during 1980 and then into a deeper downturn in 1982 that sent unemployment to nearly 11%. But the harsh medicine did the trick, and by the end of 1982 the rate of inflation was back down to 5% and eventually trended between 2% and 3% for the next 40 years until the massive distortions of the Coronavirus outbreak. Volcker’s harsh response to structural inflation inflicted pain on millions of households but ultimately triumphed in curtailing the insidious expectation of future inflation.
The current Fed led by Jerome Powell is all too aware of the risks that expectations for higher prices could again become embedded in consumer and business planning. Powell remains committed to heading it off by holding firm to a 2% target inflation rate, despite enormous pressure from Washington and Wall Street. Criticizing the Fed and second guessing their policy decisions is a popular sport, but they remember the lessons of history, and wagering against their resolve is likely a sucker’s bet.