Falstaff: “Banish Plump Jack and banish all the world”
Prince Hal: “I do, I will”
Tavern Scene, Scene IV, Act II
Henry IV, Part 1, Shakespeare
Powell’s “Play Extempore”
The most famous example of the “Play Extempore” in Elizabethan theatre is the Great Tavern Scene in Henry IV Part 1, where Falstaff and then Prince Hal, with faux amateur dramatic spontaneity, assume the role of King Henry lecturing his wayward son. Prince Hal, who had to date shared a life of drunkenness and debauchery with Falstaff, claims he will cast off the genial Sir Jack to assume a more virtuous life as King. If Jack Falstaff is inflation – self-indulgent and hedonistic – Prince Hal is Fed Chairman Powell, who after a life of notoriety as the world record money printer, has recently promised “unconditional” “commitment to restoring price stability.”1
But Jack Falstaff represents all that is pleasurable about life – easy money in our modern-day economic analogy – and Hal struggles to let Falstaff go. Eventually, on becoming King in Part II, Hal finally banishes Falstaff, re-establishing political order and virtue. As we shall see, this was the same painful journey experienced in the Stop-Go monetary and political cycles of the 1970’s, which finally culminated in unprecedented high nominal and real interest rates under Paul Volcker in 1981 that eventually banished high persistent inflation from the American economy.
Was 1970’s stagflation really all Arthur Burns fault?
Central bankers in the 1970’s – particularly Fed Chairman Arthur Burns (1970-1978) – have subsequently been made the historical scapegoat for the stagflationary era. Yet contemporary critics generally complained that Fed monetary policy under Burns was too restrictive.2 Democrats proposed a congressional directive in early 1975 ordering the Fed to provide “substantially higher” money supply growth.3 Later that year, Presidential hopeful Carter, complained “The monetary restrictions of the last few years did nothing but slow the economy. It wasn’t a sensible way to counteract the price rises that were occurring.”4
Though Burns was accused of failing to tighten fast enough in the run up to the 1972 Presidential election5, which saw a landslide re-election of Richard Nixon, until 6 years into his tenure as Fed Chairman in 1974, real interest rates were nearly always positive (See Fig 1: US 1970’s Interest Rates & Inflation). The FOMC hiked the effective Fed Funds rate to then an unprecedented 13% in June 1974 in response to the spiralling inflation set off by the OPEC oil embargo of October 1973, with Burn’s assuring “we hope to do our part in subduing [inflation]…Let there be no mistaking our determination in this.”6 This may sound familiar to Fed watchers today. Burn’s dovish pivot came 12 months into the downturn in September 1974 when Fed Funds were cut to 9.25% and then by March 1975 just 5.5%:
“Soon after unemployment rose, the administration and the Federal Reserve shifted their operations and goal from lowering inflation to avoiding or ending recession and restoring full employment,” wrote one FOMC Board Member.7 Inflation fell back to 5%, and by 1976 the economy had rebounded significantly, leaving Burns to enjoy “greater prestige and notoriety than any previous Federal Reserve Chairman.”8 “But that left inflation still well above the inflationary conditions that had prompted Richard Nixon to impose controls in 1971. There seemed to be a new plateau of distress in which neither unemployment nor inflation subsided to “normal”.”9
Fig 1: US 1970’s Interest Rates & Inflation
“The Trauma of 1980”
By contrast, Paul Volcker (Fed Chairman 1979-1987) is now lauded as the central banker who finally restored price stability, through taking Fed Funds to 20% in 1980 and 1981 (See Fig 1: US 1970’s Interest Rates & Inflation). After a long inflationary period, which also saw a supply side response in commodities (e.g., North Sea and Alaskan oil discoveries) Volcker eventually purged inflation by failing to ease rates as fast as inflation fell, with the resultant period of sustained real interest rates (1981-85) causing a “fundamental reversal in the advantage between lenders and borrowers of every kind”:
“The debtors, from families buying homes to businesses borrowing for new machinery, had benefitted powerfully from rising prices – paying back their loans in cheapened dollars. Now it was the creditors‘ turn . Old debts, contracted when inflation was running high and expected to continue, would now be paid back in “hard” dollars – money that not only retained its value but actually increased in purchasing power as prices continued to fall.”10
But the “Trauma of 1980” whereby “Volcker’s first year as chairman ended in embarrassment”11 is often forgotten. The Volcker era began on 6th October 1979, in a “Saturday Night Special” news conference, hiking the Funds Rate to 13% and announcing that the Fed would henceforth be targeting the money supply.12 On Feb 29th, 1980, the Fed Funds rate was hiked again from 15% to an unprecedented 20%. When the US economy quickly collapsed, monetary policy was immediately eased with the Fed Funds rate back at 9.5% by June 1980. By August, the recession had ended. After slowing, CPI rebounded back up to 11%. “Clearly, the war had not been won”:
“Volcker panicked” recalled one Reserve Bank President. “He was completely wrong. He was easing far too fast. When it got down to negative interest rates, I said that’s too god-damned far. The inflation rate was about 10% and the Fed Funds rate fell to 8%. He was panicked by the swings in the economy, the sudden collapse touched off by credit controls. It was the stupidest thing to do, but we did it.”13
By the November 1980 Presidential election, inflation had gone back up to 14% and by December 1980, the Fed Funds rate was back at 20% (See Fig 1: US 1970’s Interest Rates & Inflation).
This was a classic Stop-Go cycle, the kind predicted by the OECD writing in July 1974: “If the world demand grows more strongly than foreseen there will be little chance of reducing the extremely high rate of inflation; if, on the other hand, demand grows less than foreseen, there is a danger of a recession which would no doubt have an impact on inflation but which might soon lead to an excessive reversal of policy, thus preparing the way for a new burst of inflation later.”14
The Old Woke Fed
In a lecture delivered in 1979, Burns would blame the failure of central banks to restore price stability on the post-WW2 political promise of mass prosperity:
““Maximum” or “full” employment, after all, had become the nation’s major economic goal – not stability of the price level… It therefore seemed only natural to federal officials charged with economic responsibilities to respond quickly to any slackening of economic activity ...but to proceed very slowly and cautiously in responding to evidence of increasing pressure on the nation’s resources of labour and capital. Fear of immediate unemployment – rather than fear of current or eventual inflation – this came to dominate economic policy making.”15
“Viewed in the abstract, the Federal Reserve System had the power to abort the inflation at its incipient stage fifteen years ago or at any later point, it could have restricted the money supply and created sufficient strains in financial and industrial markets to terminate inflation with little delay. It did not do so because the Federal Reserve was itself caught up in the philosophic and political currents that were transforming American life and culture”16
Is the US already in recession?
Whisper it gently, we are probably already in recession. US GDP in Q1 was -1.6% and the median forecast for Q2 is just 0%. Hence, it is already at best a coin toss that the US – and probably most of Europe17 – is already experiencing two negative real GDP quarters in a row. Although we are already more advanced in the overall economic slowdown than commonly perceived, this has largely gone unnoticed because it doesn’t feel like any recession in recent memory. “Nothing in the economy works, the economy doesn’t work for anybody without price stability” Powell said in May,18 but companies (profits) and workers (wages) live in a nominal return world which is still expanding at high single digits owing to inflation: a stagflationary situation witnessed throughout most of the 1970’s (See Fig 2: US GDP 1970’s). Capital – which lives in a real return world – has been drowning in the inflationary bubble bath.
Fig 2: US GDP 1970’s
The closing of the hiking window
The Fed will deliver another probable 75bps hike on July 27th at which point Fed Funds will be at 2.5%. Quantitative Tightening will begin in June and be scaled up by September.19 On July 28th, the day after the FOMC, the first estimate of Q2 GDP will be released, likely to officially confirm the recession. Powell’s hikes have had to be front-end loaded because continuing to hike in a recession becomes much more difficult to justify. Powell’s commitment to restoring price stability will in economic recession be challenged by political pressure, particularly with mid-term elections in November. He also said in the June FOMC conference that the “neutral rate isn’t very high nowadays” which suggests that he still thinks that inflation is “transitory” after all, and another 75bps hike may get the job done. By the Sept 21st FOMC the Fed may have already made a dovish pivot – with the hiking cycle on pause – a battle won, but perhaps not the war.
Taming structural inflation will prove more difficult than sponsoring a recession. The Fed can control aggregate demand through interest rates but can do little about the long-term allocation of capital and labour needed to resolve supply side bottlenecks (which along with windfall taxes and ESG may only inhibit this response). Deflationists will get excited about the falling price of lumber or used cars, whose weighting in the CPI calculation is infinitesimal. Inflation readings will likely remain elevated, since two thirds of CPI is composed of service sector factors such as wages and rents, which were still depressed last year but are now catching up the inflation witnessed elsewhere. Inflationary spirals are by nature whack-a-mole: just when you think it’s been eliminated, it pops up somewhere else.
Reallocation of Labour
Unemployment will rise in the technology sector which expanded too fast, but labour shortages will persist in less glamourous industries, particularly energy, travel, and leisure, where previous boom and bust cycles have lessened their appeal to workers looking to build careers. This structural misallocation of resources will keep the overall labour market more resilient than normal in a recession, meaning that wage growth may prove stickier. Contrary to the myth of “high unemployment” in the 1970’s, the US labour market saw average unemployment of just 6% and robust wage growth even in recession, until Volcker’s deflationary bust in 1981 (See Fig 3: US Labour in the 1970’s). As we have seen from the travails of Arthur Burns, the political will never existed for the kind of deep and painful recession that would bring inflation busting high unemployment and lower wages. It is doubtful whether politics today is any different to that of the 1970’s.
Fig 3: US Labour in the 1970’s
Larry and Druck
Stanley Druckenmiller recently claimed that “once inflation gets above 5% it’s never come down unless Fed Funds have gotten above the CPI” and that “We’ve never had a soft landing once inflation has gotten above 4.5%.”20 This claim is validated by an analysis of US monetary history since 1955, with periods of high US inflation 1969-70, 1973-82 and 1989-90, only ending following a sustained period of real interest rates. (See Fig 4: US Monetary History Since 1954). Larry Summers has also recently published an economic paper comparing past and present inflation noting “important methodological changes in the Consumer Price Index (CPI) over time”. By reconstituting historical inflation using current CPI methodology, Summers found that “current inflation levels are much closer to past inflation peaks than the official series would suggest”; that historic inflation is overestimated using current methodology and therefore current inflation is underestimated relative to historic inflation data. This leads to the gloomy conclusion that “To return to 2 percent core CPI today will thus require nearly the same amount of disinflation as achieved under Chairman Volcker.”21
Fig 4: US Monetary History Since 1954
Whilst according to Summers, today’s inflation rate is underestimated relative to historical prints, it should be noted that not only do real interest rates still remain negative to an unprecedented historic degree (See Fig 5: Recent US Interest Rates & Inflation) but also that the post-COVID growth in US money supply (peaking at +27%) was twice the rate of peak growth (+13%) observed in the 1970’s (See Fig 6. US Money Supply Growth YOY)22 following a panicked response to COVID which saw $120bn a month of QE: asset purchases which kept going even as any economic danger had passed; $5 trillion of assets (22% GDP) added to a previously $4 trillion Fed balance sheet in just two years.23 Central banks responded “quickly to any slackening of economic activity” in their use of QE – a tool originally designed to avoid deflation in extreme economic crisis – but indulgently “proceed[ed] very slowly and cautiously in responding to evidence of increasing pressure on the nation’s resources of labour and capital” Burns might have concluded: “because the Federal Reserve was itself caught up in the philosophic and political currents that were transforming American life and culture.”24
Fig 5: Recent US Interest Rates & Inflation
Fig 6. US Money Supply Growth YOY
Any comparison of monetary policy in the 1970’s compared to the unprecedented COVID panic money printing witnessed over the past few years is distinctly unfavourable to modern day central bankers. If inflation can only be tamed – sustainably brought back under 2% – then these historical relationships suggest there is a need not only for the Fed Funds rate to be brought back above CPI (currently 8.6%) and to remain above CPI as inflation eventually falls. Since the economic ramifications of this will clearly be politically unacceptable, the logical consequence is a pro-longed period of Stop – Go economic cycles, within a stagflationary decade: the 1970’s redux.
Powell as the “New Volcker”?
Powell is being cheered on as the “New Volcker”. Financial markets faced with a difficult choice would now prefer the deflationary bust to permanently high inflation where “nothing works”. But inflationary habits are difficult to shake. The front-loading of Fed interest rate hikes means an acceleration in the tightening of financial conditions, heightening the risk of a short-term counter trend inflationary scare. Once a recession is confirmed – which could come as early as July – the political pressure on Powell – just like with Burns in 1974 and Volcker in 1980 – will likely mean that we should see a pause in the rate hike cycle in time for the mid-term elections in November, rekindling inflationary animal spirits. In any case, Powell’s estimate of the “neutral” rate looks far too low in any historic context considering the previous scale of monetary stimulus. The political will to banish inflation if it also means “banishing all the world” remains as doubtful today as it was in the 1970’s.
1FOMC June 17th 2022 statement
2In the Sept 1979 Per Jacobsson Lecture Burns explained monetary policy was constrained by politics: “As the Federal reserve kept testing and probing the limits of its freedom to undernourish the inflation, it repeatedly evoked violent criticism from both the executive and Congress and therefore had to devote much of its energy to warding off legislation that could destroy any hopes of ending inflation” Quoted in “Economist in an Uncertain World, Arthur Burns and the Federal Reserve 1970-1978” Wyatt Wells. P230
3Quoted in “Secrets of the Temple” William Greider P345
4Quoted in “Economist in an Uncertain World, Arthur Burns and the Federal Reserve 1970-1978” Wyatt Wells P204
5This accusation is disputed by Donald Kettl in “Leadership at the Fed” P136: “Legends to the contrary, Burns established that monetary policy would not become a tool of electoral politics. Nixon did get an easier money supply as the 1972 presidential election approached, but almost in spite (rather than because) of his pointed demands”
6Quoted in “Economist in an Uncertain World, Arthur Burns and the Federal Reserve 1970-1978” Wyatt Wells P136
7Arthur Brimmer FOMC Board Member 1966-74. Quoted in “Origins of the Great Inflation” Allan Metlzer
8Quoted in “Economist in an Uncertain World, Arthur Burns and the Federal Reserve 1970-1978” Wyatt Wells P178-179
9Quoted in “Secrets of the Temple” William Greider P345
10“Secrets of the Temple” William Greider P551
11Quoted in “Secrets of the Temple” William Greider P515
12“Secrets of the Temple” William Greider P123
13“Secrets of the Temple” William Greider P203
14Quoted in “The Second Great Crash” Cairncross and McRae P6
15“The Anguish of Central Banking”, 1979 P13 http://www.perjacobsson.org/lectures/1979.pdf
16“The Anguish of Central Banking”, 1979 P15 http://www.perjacobsson.org/lectures/1979.pdf
17We should note that Europe – unlike the US – do not produce timely GDP estimates, so this is pure speculation
18May 12th, 2022, Marketplace radio interview
19£30bn Treasuries and $17.5bn agency MBS from June, scaling up to $60bn and $35bn in September
24“The Anguish of Central Banking”, 1979 P15 http://www.perjacobsson.org/lectures/1979.pdf