Home Business Bad news from the Fed? We’ve been here before.

Bad news from the Fed? We’ve been here before.

by SuperiorInvest

The Federal Reserve’s decision to raise interest rates again is hardly a positive development for anyone who has a job, a business, or invests in the stock or bond market.

But it’s not a big shock either.

This is all about curbing the inflation that is running 8.3 percent per year, which is almost the highest rate in the last 40 years. On Wednesday, Fed raised the short-term federal funds rate for the third straight time to 3.25 percent and said it would raise it.

“We believe that failure to restore price stability would mean much more pain later,” said Jerome H. Powell, the Fed chairman. He conceded that the Fed’s rate hikes would increase unemployment and slow the economy.

The outlook is bleak, but it’s been worse before. The last time strong inflation tested the strength of the Federal Reserve was the era of Paul A. Volcker, who became Fed chairman in August 1979, when inflation it was already 11 percent and still growing. He managed to get it below 4 percent by 1983, but at the cost of two recession, sky high unemployment and terrible volatility in the financial markets.

How the Fed dealt with inflation back then and spent several years trying to bring it under control provides clues about what we face today.

In short, buckle up. How long the turbulence will last I cannot say. But note this: In Mr. Volcker’s time, when the pain seemed to last forever, there was a rapid and remarkable improvement.

The Volcker era began as a rough time for the economy and ended as a prosperous one. By the time Mr. Volcker resigned in August 1987, the Fed had beaten inflation — even though the unemployment rate was still around 6 percent—​​and set the country on a path to price stability that lasted for decades.

Mr. Volcker faced frequent protests early in his tenure, but eventually launched what was later called the “Great moderation.” This tumultuous period lasted long after his departure from the Fed and ended only with the financial crisis of 2007-9. As the Fed now puts it at a website dedicated to its history“Inflation was low and relatively stable while the period included the longest economic expansion since World War II.”

But how did the Volcker Fed tame inflation? It improvised, changing tactics as needed, alternating between its two mandates — “economic goals of maximum employment and price stability” — new information arrived.

Donald Kohnsenior fellow at the Brookings Institution in Washington, was a Fed insider for 40 years and in 2010 I left as vice-chairman. With his invaluable guidance, I delved into the history of the Fed during the Volcker era.

I found an amazing amount of material that provided much more information than reporters had access to at the time. In fact, while the current Fed provides a huge amount of data, what goes on behind closed doors is in some ways better documented for the Volcker Fed.

That’s because transcriptions Fed meetings from that period were reconstructed from tapes that, Mr. Kohn said, “nobody was thinking about when they were talking because nobody knew about them or expected it to ever be released except, I guess, Volcker.” In the 1990s, when the Fed began producing transcripts available with a five-year time delay, Mr. Kohn said, meeting participants “were aware that they were going down in history, so we became more reticent about what we said.”

So reading the Volcker transcripts is like being a fly on the wall. Some names of foreign officials have been scrubbed, but most of the material is there.

In a telephone interview, Mr. Kohn identified two critical “Volcker moments” discussed by Mr Federal Reserve in Dallas conference in June. “In both cases, the Fed moved quietly and surprised people by changing its focus and approach,” he said.

The first important episode took place on October 6, 1979. That’s when the Fed deliberately shocked the financial world by shifting the focus of its public statements from interest rates, now its main focus, to the money supply, which is now secondary. concern.

The Fed has always had the ability to adjust both interest rates and the money supply. But nowadays it is much harder to define money. The amount of money in circulation and the frequency with which it is exchanged has become too fluid to be reliably measured and manipulated.

In the 1970s, the money supply was much more talked about than it is now Congress, financial circles and academic institutions. Students of economics may remember Milton Friedman saying: “Inflation is always and everywhere a monetary phenomenon.”

For Fed watchers, the central bank’s shift in emphasis had practical consequences. Richard Bernstein, a former chief investment strategist at Merrill Lynch who now runs his own firm, said at the time: “You needed a calculator to figure out what numbers the Fed put out. By comparison, there are practically no numbers now. Just look at the words of the Fed statement.”

The Fed’s methods for dealing with inflation are murky things. But his discussions of the problem in 1982 were poor, and his decisions seemed to be based as much on psychology as on traditional macroeconomics.

As Mr. Volcker said at the Federal Open Market Meeting on October 6, 1979“I described the state of the markets as in some sense as nervous as I have ever seen them. He added: “We are by no means dealing with a stable psychological or stable state of expectation. And we’re probably losing ground on the inflation front.”

This psychological uncertainty, he continued, “is reflected in extremely volatile financial markets.”

Under these circumstances, he told committee members, “The traditional method of making small movements has in some sense, though not entirely, run out of psychological gas.”

So what could the Fed do? He needs to make a big “psychological” statement, he said, and absolutely convince the markets that he is dead serious about stopping inflation.

He suggested making a fundamental change in her public attitude, and the committee agreed. It would focus on controlling the money supply, effectively encouraging short-term interest rates to rise sharply in response to market pressures. And they took off. The federal funds rate has reached staggering levels 17 percent until March 1980. The Fed plunged the economy into one recession and then, when the first failed to sufficiently curb inflation, into a second recession.

In the fall of 1982, in the depths of the recession, the Fed convinced the markets that it meant business. The Unemployment rate it was 10.8 percent, a post-war high that wouldn’t be surpassed until the coronavirus recession of 2020. But back in 1982, even the people at the Fed were wondering when the economy would begin to recover from the damage done.

The fall of 1982 was the second “Volcker moment” noted by Mr. Kohn, who was in the room during the meeting. The Fed has decided that inflation is falling — even though in September 1982was still in the range of 6 to 7 percent. The economy was shrinking sharply, and extraordinarily high interest rates in the United States reverberated around the world, exacerbating debt crises in Mexico, Argentina, and soon the rest of Latin America.

IN Fed meeting that October, when one official said: “There have certainly been some other problematic situations” in Latin America, Mr. Volcker replied: “That’s the understatement of the day, if I do say so myself.”

In the United States, big banks were under considerable stress, “largely because of domestic concerns,” he said. A few months before the meeting, in July, Penn Square Bank in Oklahoma collapsed, the predecessor of another failure come.

“We are in a global recession,” Mr. Volcker said. “I think there’s no doubt about that. He added: “I don’t know of any major country in the world that is expanding. And I can think of a lot of them that have a real drop. It is clear that unemployment is at a record high. It rises practically everywhere. In fact, I can’t think of any major country that is an exception.’

It was time, he and the others agreed, to provide relief.

The Fed needed to make sure that interest rates would fall, but the method of targeting the money supply was not working properly. It could not be calibrated precisely enough to warrant a decline in interest rates. In fact, interest rates rose in September 1982 when the Fed wanted them to fall. “I’m totally displeased,” Mr. Volcker said.

So it was time to shift the Fed’s focus back to interest rates and cut them resolutely.

It wasn’t an easy move, Mr. Kohn said, but it was the right one. “It took confidence and some fine judgment to know when it was time to relax,” he said. “We’re not there today – inflation is high and now is the time to tighten – but at some point the Fed will have to do it again.”

The Fed’s 1982 pivot had a surprising return on financial markets.

As early as August 1982, central bank policymakers were debating whether it was time to loosen financial conditions. Word got out to traders, interest rates fell, and the previously lackluster S&P 500 started to rise. He gained almost 15 percent in a year and continued. This was the beginning of a bull market that continued for 40 years.

In 1982, the conditions that started the booming optimism in the stock market did not happen overnight. The Volcker-led Fed had to correct itself repeatedly as it responded to major crises at home and abroad. It took years of pain to get to the point where it made sense to turn around and for businesses to start hiring again and for traders to go all-in on risky assets.

Today, the Fed is once again embarking on a grand experiment, even as Russia’s war in Ukraine, the ongoing pandemic and political crises in the United States and around the world threaten millions of people.

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 plan and invest for long-term prosperity.

I’ll be back with details on how to do this.

But I would try to stay permanently invested in both the stock and bond markets. The Volcker era shows that when that moment finally comes, big changes in financial markets can happen in the blink of an eye.

Source Link

Related Posts

%d bloggers like this: