Year: 2021

May 18, 2021

I realized recently that while the war on inflation from the Volcker era has been thoroughly analysed and explained over the past 30 years, little had ever reached me to explain how inflation was able to creep in to start with, other than with well-known major supply shocks like the OPEC oil embargo of 1973 or the Iranian embargo of 1979.

As it happens, the latest Grant’s Interest Rate Observer started me on the discovery journey of the 1965-1970 period when U.S. inflation sneaked its way from 1% to 6%. See if you find similarities with today.

(…) Until Volcker, inflation had rarely encountered an opponent as determined as William McChesney Martin, the longest-serving Fed chairman (1951–70), who helped to negotiate the accord with the U.S. Treasury that ended the postwar pegging of government bill and bond yields. Martin was all for price discovery in the bond market and price stability at the checkout counter. (…)

Yet the man who hated inflation turned out to be the author of the Great Inflation. That he failed at the work at which he most wanted to succeed—he retired from office as the CPI was running at the shocking year-over-year rate of 6%—is a fact to weigh in the balance of inflationary risks today. (…)

During the 1960’s there was no supply shock and no wage spiral and yet, as the Richmond Fed wrote in 2016

(…) high inflation, so closely associated today with the 1970s, was already ticking upward in the 1960s. While it averaged only 1.5 percent a year from 1952 to 1965, it rose to an annual average of 4.5 percent starting in 1966. In 1969, it hit an 18-year high of 5.75 percent. In retrospect, many scholars now believe that the roots of the 1970s inflationary spiral can be found in the 1960s. The economic historian Allan Meltzer has described 1965 as a turning point on inflation.

But how did it actually happen, how did it evolve from a long, 13 years, noflation period to a creep, then a rise and then a surge? Milton Friedman said that “inflation was always and everywhere a monetary phenomenon in the sense that it is and can be produced only by a more rapid increase in the quantity of money than in output”. In non-economist words, inflation is essentially caused by demand rising faster than supply. Friedman explained it with a particular focus on the sixties:

To each businessman separately it looks as if he has to raise prices because costs have gone up. But then, we must ask, ‘Why did his costs go up? Why is it that from 1960 to 1964 he didn’t find that he had to pay so much more for labor he had to raise prices, but that suddenly from 1964 to 1969 he did?’ The answer is, because, in the second period, total demand all over was increasing.

President John F. Kennedy, a liberal Democrat, was elected in 1960, a recession year, winning the popular vote against Richard Nixon by 112,827, a rather narrow margin of 0.17%. By the end of 1962, his political fortunes looking bleak with the unemployment rate rising towards 6%, Kennedy decided that only a bold domestic program would provide political momentum in time for the 1964 elections.

Given the stronger economy in 1963, Republicans and conservative Democrats in Congress insisted on a balanced budget. Kennedy disagreed, arguing that “a rising tide lifts all boats” and that strong economic growth would not continue without help from fiscal policy. JFK was convinced that economic stimulation and civil rights legislation would be decisive in 1964.

When Lyndon Johnson became President after Kennedy was assassinated in November 1963, his focus was on his own elections less than one year away. The unpopular Texan, a conservative southern liberal with an acute political sense, was also convinced of the need to continue Kennedy’s drive on economic stimulation and civil rights to have any chance of confirming his presidency.

As Kenneth T. Walsh wrote in the U.S. News & World Report

Few presidents aspired to do more in office than did Lyndon Johnson,” writes political scientist Alvin Felzenberg in The Leaders We Deserved (and a Few We Didn’t). “A man of gargantuan appetites and ambitions, Johnson wanted nothing less than to break the record of his hero, Franklin Delano Roosevelt, who had greatly expanded the role of the federal government in American life. Johnson wanted to pick up where FDR had left off.

LBJ had spent 12 years in the House and another 12 in the Senate where, as majority leader, he became known as the Master of the Senate. He knew all the nuts and bolts, and all the tricks, to swiftly move legislation. Walsh continues:

He immediately set about persuading Congress not only to approve the martyred president’s agenda but to move far beyond the bills Kennedy had in mind. What followed was a huge profusion of legislation to improve social welfare, including the historic Civil Rights Act of 1964 that opened the way for greater equality for African-Americans, federal aid to education, and a large variety of social programs that Johnson called the “War on Poverty.” (…)

Another part of Kennedy’s legacy was even more troublesome—support for South Vietnam in its bitter conflict with the north. Johnson positioned himself as less bellicose than Goldwater in the 1964 campaign, and his relative moderation was appealing to voters. (…)

Johnson won the 1964 election by a landslide. This enabled him to continue expanding what he called his “Great Society” programs as he bulldozed and cajoled a Democratic-controlled Congress into following his lead. Among the vast array of bills that he got passed were health assistance for the elderly and the poor and measures to protect the environment, increase aid to education, prohibit discrimination in housing, and protect consumers.

His “relative moderation” on Vietnam greatly underestimated the Viet Cong’s strength and determination. Unwilling to become the first president to lose a war, he escalated America’s involvement, even hiding to Congress and the American people the true human and monetary costs of the war.

The result was a huge increase in defense spending (red line) adding to LBJ’s Great Society programs. Between mid-1963 to the end of 1966, real GDP grew 6.1% on average, following +4.0% since the end of 1961. Needless to say, this broadly booming demand put a lot of strain on available resources.

When LBJ realized his lifelong dream in November 1964, inflation was 1.3%. It had crept up to 1.7% at the peak of real consumption growth in November 1965 (blue line), but, even after Bill Martin’s Fed hiked rates in December 1965, inflation then took a life of its own reaching 3.8% in October 1966 and went all the way to 6.4% in early 1970.

As the Richmond Fed explains, Johnson’s people

(…) held that the Fed’s primary role was keeping unemployment very low, around a target of 4 percent, and providing stimulus through low interest rates. Unlike Martin, they believed allowing a modest amount of inflation to reach low unemployment was not risky; as long as the economy had not reached full employment, it would have enough slack to keep wage pressures in check. And if inflation did emerge, they believed fiscal policy, rather than the Fed, was the most effective tool to manage it. (…)

Against the Powell Fed telling us that the current inflation spike is transitory and that, in the unlikely event that it were not, the Fed has the tools to intervene, the Richmond Fed offers the lessons of 1965:

Martin strongly believed that the Fed’s core mission was price stability. But he also adhered to the view that the Fed and the other branches of government would work most effectively if they respected the interaction of their policy decisions. As part of this approach, he believed, the Fed had to communicate effectively with Treasury and Congress to achieve a common set of goals. Sometimes this meant that the burden of adjustment (i.e., tightening policy) was on the Fed, since Congress, as the democratically elected branch with the power of the purse, determined the course of fiscal policy, including whether to run deficits. “It is monetary policy that must adapt itself to the hard facts of the budget,” is how Martin put it in a 1965 speech. “Not the other way around.”

Later, Martin was to observe that

Nothing in the background or history of the Federal Reserve Act indicates any misunderstanding by its framers of the laws of supply or demand, or any belief that a Federal Reserve System could control or successfully manipulate, for long, supply and demand forces. Certainly the history of the years I have touched upon tonight demonstrates that you can change the nature of demand and alter the composition of supply, but you can’t abolish the law of supply and demand. That is a law we must reckon with always, for whenever we ignore the working of the market we do so at our peril, and ultimately must pay the piper.

So, unsurprisingly, the Richmond Fed continues,

(…) the rate hike of 1965 did not, in fact, turn a corner on inflation. In the years that followed, fiscal stimulus was ample, war spending kept rising, and the deficit grew. But FOMC members were often divided, and their policy decisions reflected this ambivalence. Furthermore, while Martin saw monetary and fiscal policymakers as obligated to work together to promote price stability and growth, he discovered that dealing with this particular White House and Congress was often a one-way street. (…)

Martin was at odds not only with those officials in the executive branch, but also with some of his fellow FOMC colleagues. The appointments of George Mitchell (1961) and Sherman Maisel (1965) as governors effectively ensured a strong “dovish” plurality. Martin preferred to avoid tipping the scales during votes until he knew where a majority was heading, but as inflationary signs picked up, he increasingly tried to bring the Reserve Bank presidents — who generally were more independent — to his side. (…)

Martin and others on the FOMC soon became alarmed that inflation continued to rise despite the December 1965 hike. It reached 2.8 percent by March 1966, and the effective fed funds rate began to creep over the discount rate, by around a half a percentage point that summer. In July 1966, without the prospect of any action on taxes, the Board asked banks to ration credit rather than raising benchmark rates. This time, the move had broad support.

In the following months, Martin also made progress in another priority: getting high-level support to convince Johnson and Congress to raise taxes to pay for Johnson’s programs. Higher taxes, Martin believed, would relieve the Fed of the need to tighten rates further to offset rising deficit financing. By fall 1966, both Ackley [chairman of the Council of Economic Advisers] and Fowler [Treasury Secretary] began siding with Martin on this point, even though both were unhappy about the December rate hike. Still, Johnson continued to resist. Powerful fiscal conservatives in Congress wanted domestic spending cuts in return if they were going to raise taxes — and that was a bargain Johnson refused to consider.

The summer tightening of 1966 did dampen inflation temporarily but brought with it the side effect of a deep credit crunch. By spring 1967, Martin felt that inflation had slowed down enough to allow the Fed to dial the discount rate back to 4 percent — on the condition that Johnson would finally push his tax hike proposal in Congress. Again, the president resisted.

It was not until spring 1968, when the Johnson administration and the Fed had to scramble to address a balance-of-payments crisis caused by destabilization in the gold market and a looming collapse of the British pound, that Johnson and Congress found the support to move the tax hike package. (It was also at this point that Johnson had decided against running for re-election.) But by then both interest rates and inflation were moving higher. In fact, starting in fall 1967, the Board had begun raising the discount rate again, and by July 1969 it reached 6 percent; the effective fed funds rate topped 10 percent.

What were the drivers of this inflation? To be sure, Johnson’s policies produced a sharp rise in deficit spending, which Johnson failed to offset with higher taxes until the waning days of his presidency. From 1965 to 1968, the deficit jumped from 0.2 percent of gross domestic product to 2.7 percent. But the inflation of the 1960s also can be traced to the expansion of the money supply. From the mid-to-late 1960s, it grew at an annualized rate of 5 percent to 7 percent, well above the average of 4 percent in the first half of the decade. (…)

The persistence of inflation weighed heavily on Martin in his final days as chair — so much so that at his lavish farewell party at the White House, he shrugged off a series of laudatory toasts. Instead, he offered an apology for the state of the economy. “I wish I could turn the bank over to Arthur Burns as I would have liked,” he said. “But we are in very deep trouble. We are in the wildest inflation since the Civil War.” He then sat down, to uneasy applause.

Milton Friedman also used the famous “transitory” word but in a rather different transition process:

The only cure for inflation is to reduce the rate at which total spending is growing. There is no way of slowing down inflation that will not involve a transitory increase in unemployment, and a transitory reduction in the rate of growth of output. But these costs will be far less than the costs that will be incurred by permitting the disease of inflation to rage unchecked.

It will be interesting to compare the future sequence of events with that of the sixties.

We know that Democrats will totally focus on maximizing their odds for 2022 and 2024.

The unknown, however, is the how the Fed’s recently modified interpretation of its dual mandate will affect its future policy. At the end of August 2020, the Fed released an updated statement to the Longer-Run Goals and Monetary Policy Strategy published in 2012 and reviewed in 2019. The Brookings Institute:

The statement gives Congress, the public, and the financial markets a sense of how the FOMC currently interprets its congressional mandate—to aim for maximum employment and price stability—and the framework it will use to make decisions on short-term interest rates and other monetary policy tools. To compare the old and new Fed statements of long-term goals, see this guide. Going forward, the Fed plans to conduct a review of the statement every five years.

The new statement introduces the apt moniker FAIT, Flexible Average Inflation Targeting, giving the FOMC the flexibility to let inflation rise above 2% for an undefined period after a period of below 2% inflation.

On unemployment, Jerome Powell said (my emphasis):

The old statement said the Fed would adjust policy based on “deviations from its maximum level.” The new one says the Fed will base its decisions on “assessments of the shortfalls of employment from its maximum level. The change in wording may appear subtle, but it reflects our view that a robust job market can be sustained without causing an outbreak [undefined] of inflation.

To the Economic Club of New York on February 10, 2021, Powell provided additional precisions:

The revised statement emphasizes that maximum employment is a broad and inclusive goal. This change reflects our appreciation for the benefits of a strong labor market, particularly for many in low- and moderate-income communities. Recognizing the economy’s ability to sustain a robust job market without causing an unwanted increase in inflation, the statement says that our policy decisions will be informed by our “assessments of the shortfalls of employment from its maximum level” rather than by “deviations from its maximum level.” This means that we will not tighten monetary policy solely in response to a strong labor market.

This Fed has given itself much flexibility: flexible on inflation and flexible on its “assessments of the shortfalls of employment from its maximum level” and its effects on minorities.

We will all have to adjust to the Fed’s subtleties as Powell explained at at National Community Reinvestment Coalition event on May 2, 2021:

Powell noted that the Fed’s central mandate is to ensure a strong economy that would lift everyone, but pointed to fiscal and monetary tools that could ensure a more targeted response, such as strong supervision of racial equality laws and efforts to focus on community financial institutions that serve minority populations.

Allowing deep-rooted inequalities to persist, he said, would have implications for the wider economy.

“The Fed is focused on these long-standing disparities because they weigh on the productive capacity of our economy,” he said.

“We will only reach our full potential when everyone can contribute to, and share in, the benefits of prosperity.”

If Janet Yellen moved from the Fed chair to Treasury Secretary, one could say that Jerome Powell has set a foot in each job. Such dynamic duo of very similarly noble minds is likely to test the historical and necessary independence of the Federal Reserve. But rest assured, Powell wrote to Senator Rick Scott on April 8, 2021

We understand well the lessons of the high inflation experience in the 1960s and 1970s, and the burdens that experience created for all Americans. We do not anticipate inflation pressures of that type, but we have the tools to address such pressures if they do arise.

Interest rates being where they are, Powell must know he will need teamwork if “we” need to “address such pressures if they do arise”. But he may be underappreciating the importance of 2022 and 2024 in the Democrat politicians’ agenda.

As William McChesney Martin learned, “you can’t abolish the law of supply and demand. That is a law we must reckon with always, for whenever we ignore the working of the market we do so at our peril, and ultimately must pay the piper.”