ANN/THE STRAITS TIMES – The Federal Reserve’s decision to raise interest rates again is hardly a positive development for anyone with a job, a business or an investment in the stock or bond market.
But it isn’t a great shock, either. This is all about curbing inflation, which is running at 8.3 per cent annually in the United States (US), near its highest rate in 40 years.
On September 21, the Fed raised the short-term federal funds rate for a third consecutive time, to 3.25 per cent, and said it would keep increasing it.
“We believe a failure to restore price stability would mean far greater pain later on,” Fed chair Jerome Powell said, while acknowledging the hikes would raise unemployment and slow the economy.
The outlook is gloomy, but it has been worse before. The last time severe inflation tested the mettle of the Fed was the era of Paul Volcker, who became central bank chair in August 1979, when inflation was already 11 per cent and still rising. He managed to bring it below four per cent by 1983, but at the cost of two recessions, sky-high unemployment and horrendous volatility in financial markets.
How the Fed grappled with inflation then, and struggled for years to bring it under control, provides clues about today’s situation.
Briefly put, buckle up. How long the turbulence will last? In Volcker’s time, when it seemed that the pain would go on forever, there was a quick and remarkable improvement.
The Volcker era started as a rough time for the economy and ended as a prosperous one. By the time he stepped down in August 1987, the Fed had vanquished inflation and had set the country on a path towards price stability that lasted for decades.
Volcker faced frequent protests early in his term, but ultimately ushered in what was later called ‘The Great Moderation’. This halcyon period lasted long after he left the Fed, and ended only with the 2007-09 financial crisis.
But how did the Volcker Fed tame inflation? It improvised, changing tactics as needed and pivoting between its two mandates – “the economic goals of maximum employment and price stability” – as new information arrived.
The first important episode took place on October 6, 1979. That was when the Fed deliberately shocked the financial world by shifting the focus of its public statements from interest rates – its main focus now – to the money supply, which today is a secondary concern.
The Fed has always had the ability to adjust both interest rates and the money supply. But it’s much harder to define money these days. The quantity of money in circulation and the frequency with which it is exchanged have become too fluid to be reliably measured and manipulated.
The Fed’s methods of dealing with inflation are abstruse stuff. But its conversations about the problem in 1982 were pithy, and its decisions appeared to be based as much on psychology as on traditional macroeconomics.
As Volcker said at a Federal Open Market Meeting on October 6, 1979: “I have described the state of the markets as in some sense as nervous as I have ever seen them.” He added: “We are not dealing with a stable psychological or stable expectational situation by any means. And on the inflation front, we’re probably losing ground.”
This psychological uncertainty, he went on, “is being reflected in extremely volatile financial markets”. Under those circumstances, he told committee members: “The traditional method of making small moves has in some sense, though not completely, run out of psychological gas.” So, what could the Fed do? It needed to make a big “psychological” statement, he said, and absolutely convince the markets it was deadly serious about stopping inflation in its tracks.
He suggested making a major change in its public posture, and the committee agreed. It would focus on controlling the money supply, effectively encouraging short-term interest rates to soar in response to market pressures. And soar they did. The federal funds rate reached an astonishing 17 per cent by March 1980. The Fed plunged the economy into one recession and then, when the first one failed to curb inflation sufficiently, into a second.
The Fed decided that inflation was coming down – although in September 1982, it was still in the six per cent to seven per cent range. The economy was contracting sharply, and the extraordinarily high interest rates in the US had ricocheted worldwide, worsening a debt crisis in Mexico, Argentina and, soon, the rest of Latin America.
In a Fed meeting that October, when one official said that “there have certainly been some other problem situations” in Latin America, Volcker responded: “That’s the understatement of the day, if I must say so.” In the US, major banks were under considerable stress, “largely from domestic concerns”, he said. A few months before the meeting, in July, the Penn Square Bank in Oklahoma had collapsed, a precursor of other failures to come.
It was time, he and others agreed, to provide relief.
The Fed needed to make sure that interest rates moved downwards, but the method of targetting the monetary supply wasn’t working properly. It could not be calibrated precisely enough to guarantee that interest rates would fall. In fact, interest rates rose in September 1982, when the Fed had wanted them to drop. “I am totally dissatisfied,” Volcker said.
It was, therefore, time to shift the Fed’s focus back to interest rates and to resolutely lower them.
The Fed pivot in 1982 had a startling payoff in financial markets. As early as August 1982, policymakers at the central bank were discussing whether it was time to loosen financial conditions. Word trickled down to traders, interest rates fell and the previously lacklustre S&P 500 started to rise. It gained nearly 15 per cent for the year and kept going. That was the start of a bull market that continued for 40 years.
When will the big pivot happen this time? I wish I knew. The best I can say is that it would be wise to prepare for bad times but to plan and invest for prosperity over the long haul. I would try to stay invested in both the stock and bond markets permanently. The Volcker era demonstrates that when the moment has at last come, sea changes in financial markets can occur in the blink of an eye.