Source: Federal Reserve Board, Ruffer calculations, both nominal interest rate series are deflated by a survey-based measure of one-year ahead expected inflation
CONDEMNED TO REPEAT?
The historical lesson may not come from Volcker’s Fed, but from an episode a decade prior. Like Powell today, William McChesney Martin presided over a rapid and abrupt hiking cycle, at the end of the 1960s. In 1969, his FOMC lifted real short-term interest rates by 350bps, the most severe monetary squeeze in the post-war period. There was no shortage of hawkishness while the economy was booming back then. Like today, inflation accelerated materially and unexpectedly.
But, when the 1970 recession arrived, there was neither the political will nor the intellectual support inside or outside the Fed to keep policy tight, despite elevated inflation. Burns cajoled the FOMC to loosen policy aggressively once the economy had rolled over (Figure 9). Recession was expected to bring down inflation sharply. but the disinflationary impulse created by the 1970 downturn was woefully insufficient to rid the US economy of its inflation problem.
Once the economy had entered recession, the Fed reversed course rapidly, and with real gusto. Despite lingering concerns about inflation, it did not wait for evidence that inflationary pressures were subsiding once the jobs market had turned down. But it was never enough. The 1971-72 upswing began with underlying inflation far above what today would be consistent with the Fed’s mandate. The policy error was not a lack of hawkishness as policy was tightened. The miscalculation was the urgency and aggressiveness of the easing cycle during the recession.
THE CAVALRY WILL COME, JUST TOO LATE
At best, it is going to be an uphill struggle for central banks in light of the GFC’s political legacy. At worst, they will fall into the same intellectual trap as Burns’ FOMC. The instinct towards institutional self-preservation is strong amongst central bankers.
The post-pandemic boom has created the political space for dispensing tough monetary medicine. But that space could evaporate rapidly once unemployment is rising and headline inflation is falling. It will disappear altogether if financial markets become disorderly. The Fed put may be out of the money, but not that far out.
After all, financial conditions remain a critical input into the Fed’s forecasting process. Those of a dovish persuasion on the FOMC will be hard pressed to ignore what the models tell them: that sharply lower equity prices and wider credit spreads herald a recession and broad disinflationary pressures. FOMC participants are adamant they “will keep policy restrictive” until the job is done. But other than the brutal tightening cycle in 1981, the Fed has never kept policy restrictive for some time.
“The monetary cavalry will arrive, limiting the dangers for Main Street, but it won’t arrive soon enough to save Wall Street in this cycle.”
Easing cycles tend to begin a few months after the peak in policy rates, as much because politics demands it as because economic conditions warrant it. The lag in this cycle will be somewhat longer than others, which is the main reason to fear an air pocket. But the unique political circumstances that made it possible to extinguish inflation in 1980-82 simply do not exist today. We doubt any of the major central banks will be able to resist the siren call of monetary largesse once the political elite has started fighting recessionary fires.
The monetary cavalry will arrive, limiting the dangers for Main Street, but it won’t arrive soon enough to save Wall Street in this cycle.
So the stage is set for a recession that is short and shallow but accompanied by a nasty bear market. From which will emerge an inflationary post-recession recovery.
The transition to a financial market regime of greater volatility, inflation risk and macro-economic turbulence will be complete.