Not Since The Days of Jimmy Carter
In the mid-1970s due to a combination of unusual events, inflation rates rose substantially. The primary culprits were a global drought and extraordinarily high food prices. More importantly, the OPEC cartel withheld oil from the market that resulted in a high single digit inflation rate.
After a time, investors in the fixed income market came to realize that steady inflation had resulted in a steady reduction in the purchasing power of their fixed income investments. In a classic reaction to inflation, bond holders dumped bonds, causing bond prices to decline until the market yields rose sufficiently to attract investor who felt they could earn a high enough yield to cover the inflation “tax” on their fixed income investments.
In that episode, a new Fed Chairman was appointed in the midst of stagflation with high unemployment. The Federal Reserve believed the situation called for a textbook response of easing monetary policy to create bond purchasing power in order to lower market yields and stimulate a Keynesian monetary multiplier to deal with the slumping economy and high unemployment.
It was a 1970s version of QE2.
But a funny thing happened on the way to prosperity. Wealth fled the U.S. capital markets (especially to Germany and Switzerland), causing foreign currencies and goods to become more expensive. Hence “import” inflation especially oil worsened. The now-higher inflation number in turn caused bond investors to further turn away from U.S. bonds and bond prices fell despite the Fed bond buying program. At the culmination of this episode, market interest rates rose to 14 percent for long Treasuries and mortgages could be had at 18 percent.
A well meaning Fed and a well-meaning President Carter, who mentioned that inflation is the friend of a peanut farmer (his prior job experience), resulted in a loss of confidence on a grand scale for the Fed and its Chairman, the President, the U.S. currency, and the wisdom of holding an allocation of U.S. fixed income bonds in a portfolio. Inflation resurged, and as academics talk of these things, the Fed managed to create inflation expectations on a grand scale in excess of the already high and rising inflation rate.
At that point, a champion of hard money was needed to lower inflation expectations and brings back under control the loss of confidence in the dollar and bonds. Paul Volcker was summoned to enter stage left as the yet new Fed Chairman. His mission was to regain investor confidence so they would again comfortably park wealth in dollar denominated assets. Not only did investors need reassurance that their wealth would not be exposed to depreciation, but the Fed also had to answer to Congress that sought to limit Fed discretionary power.
Volcker’s defense of the dollar and dollar-denominated assets required an announced plan of monetary austerity. This took the form of a pledge that the money growth rate would be equal to the GDP growth rate. There was no room for monetary discretion even in an emergency. Volcker’s Fed austerity program was monetary policy on autopilot. No deviations of any kind were allowed, no matter how compelling the emergency and the bond market kept the Fed on its radar screen at all times.
What was the cost and how long did it take for the markets to regain confidence in the Fed and the currency? The cost was recessions and high unemployment for about a half a decade, and despite a decline in the inflation rate, market yields continued to linger in the stratosphere. Only gradually over the next decade did the inflation premiums priced into U.S. fixed income yields dissolve.
Given the inflation shock and given the long memory of the market, the Fed for many years thereafter had to toe the line and pay homage to the zero inflation mandate of The Full Employment Act though cyclical deviations were tolerated if not welcomed. All this changed with the recent QE2’s large scale bond-buying program. It was beyond the tolerance of the market. The Fed stepped over the invisible line.
The l970s inflation episode is now being recounted in the markets especially how bond prices fell despite the Fed’s large scale bond-buying. It is true again today. The long Treasury prices have declined 11 percent since QE2 was first discussed in September and yields have jumped 100 basis points. That occurred because private investors have a larger portfolio than the Fed and they wanted no part of inflation risk. Wealth fled not for Germany or Switzerland as in days of yore, but to the perceived safer havens of today – countries whose economies are growing and which have not lost control of their fiscal deficits. In this episode, wealth isn’t waiting around for a new outbreak of inflation, but investors have sought protection prior to the event (unlike the l970s when wealth waited around until it was depreciated).
There are many contemporary parallels and ironies to the “Not since Jimmy Carter” story which is the story of how the central bank can create inflation expectations by its actions even in the absence of actual inflation. It is also the story of the ramifications of doing so.
QE2 has made a bad situation worse in the following ways: market yields have increased substantially, with fixed mortgage rates up nearly 100 basis points, damaging an already distressed housing market. Wealth has fled to commodities and precious metals and today’s perceived safer ports of call. As a result the prices of products from those countries are now adding to “import” inflation (imports are now rising at a 3.7% rate). But perhaps more important is the damage to the Fed’s respectability, rendering it political vulnerable.
Ron Paul’s ascendency to the Chairmanship of the House Financial Services Committee means hearings will be held to embarrass the Fed and rein in its independence to engage in QEs of any type. And though the Fed met this week and decided to continue with the QE2 bond purchase program (for now), the Fed’s discretion is effectively reined in even without a legislative change to its mandate. Bernanke and company are on the defense, trying to explain monetary policy to the public and Congress, which is a tougher audience than my undergrad or graduate students. The public and Congress are angry about dollar depreciation and are not interested in the economic justification for QE2.
On a more subtle note going forward, this episode might effectively constrain the government’s future attempts to monetize government debt when the entitlements really blow up the U.S. fiscal deficit. As has happened in Europe, the bond market, rather than President Obama’s deficit commission, will likely constrain government spending.
Ultimately, it looks like monetary austerity is again on the radar screen. And don’t be surprised if Paul Volcker again enters stage left from his current position as a White House adviser to do his patriotic duty, restoring confidence in the currency. The Fed’s inflation-fighting credentials took 30 years to earn and have been too easily squandered.