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For the Fed, a Red Card From the Seventies

Thought Leader: Niall Ferguson
December 18, 2022
Source: Bloomberg
Written by: Niall Ferguson

Monetary policy is more like the World Cup than it is like mathematics or great literature. As we have seen repeatedly in Qatar this year, the difference between victory and defeat can be a matter of very fine judgments and sheer luck. And when a manager changes his team’s tactics, it can operate with immediate effect — or with a mystifying lag.

Brazil ought to have beaten Croatia in the quarterfinals, but Brazil’s defenders lost concentration in extra time and Bruno Petkovic equalized, opening the way to a penalty shoot-out, his team’s specialty. Yet in the semifinals, Argentina, inspired by their talismanic maestro Lionel Messi, swept the same Croats aside 3-0.

To see what monetary policy failure looks like, however, take a trip to Buenos Aires, as I did a week ago. You will look in vain for maestros in the Central Bank of the Argentine Republic. Inflation is running at 100% a year.

As I write, I cannot tell if Argentina will win their third World Cup today. Perhaps Messi will fulfill his and his country’s dream. Or perhaps a single moment of blistering acceleration by Kylian Mbappé  will decide the game in France’s favor.

In much the same way, I cannot tell if Jay Powell, the Federal Reserve chairman, will heroically win his fight against inflation in 2023, or ignominiously lose it.

Last week’s inflation data encouraged his supporters to scent victory. In a conversation with my hirsute friend David Zervos of Jefferies LLC, I detected mounting excitement that Powell might pull off the mythical soft landing: a rapid decline in inflation without a recession. But on the same day I also discussed the issue with former Treasury Secretary Larry Summers, who dismissed a soft landing as the economic equivalent of Captain Chesley “Sully” Sullenberger landing US Airways Flight 1549 on the Hudson River after bird strikes took out both engines.

With Wednesday’s half-a-percentage-point hike, the Fed has raised its policy rate (the federal funds target rate) by 425 basis points in the space of nine months, or an average of 47.2 basis points per month. This is the second-fastest hiking cycle since World War II. The only faster rise in rates occurred under Chairman Paul Volcker in late 1980 and 1981, when the Fed hiked the discount rate by 50 basis points per month for a cumulative 400 points over eight months. We’ve all heard Powell say Volcker is his role model. Here’s the proof.

According to market expectations on Wednesday morning, the Fed was expected to reach its terminal (i.e., maximum) rate of somewhere between 4.75% and 5% at its March or May meeting next year — and then to cut by 75 basis points between then and January 2024. That prospect of rate cuts temporarily kept investors cheerful after what has been, for bonds and stocks alike, a wretchedly bad year.

Such a policy trajectory is far from unrealistic. The Fed has cut not long after finishing a hiking cycle several times in its history. Most recently, under Powell, the Fed cut rates in July 2019, seven months after delivering its last hike. Overall, following a hiking cycle, the Fed has paused by an average of 6.3 months and a median of four months before cutting rates. In that sense, market pricing on Wednesday morning was in line with Fed history.

It is also easy to imagine reasons why the Fed might want to ease monetary policy next year. Ever since the UK gilts market seized up in September, forcing Bank of England intervention, other central banks have been worrying that their monetary policy tightening could trigger a financial crisis in one corner or another of the global financial system.

There was a flurry of concern last month when Blackstone Inc. said it would limit the amount of money investors could withdraw from its $69 billion flagship real-estate fund, following a surge in redemption requests, one of a number of signs that investors are fretting about US real estate. As well they might. The economists Nick Bloom, Steve Davis and co-authors point out that working from home is proving remarkably persistent, even if the Covid-19 pandemic has long since ceased to be our No.1 preoccupation  (apart from in China). The percentage of paid full days worked from home by Americans has risen sixfold, from 5% before the pandemic to 30%, where it has held pretty steady for the past two years.

Another relevant economics paper is Akinci et al. on “the financial stability interest rate” (which they call r**, not to be confused with r*, the neutral interest rate) — the threshold interest rate above which the central bank triggers a problem of financial stability.

“Persistently low real rates induce an increase in financial vulnerabilities and a consequent decline in the level of r**,” the authors write. “As the banking sector becomes more leveraged, the financial stability interest rate becomes lower. This has implications for monetary policy, in that even relatively low levels of the real interest rate could trigger financial instability.”

It’s always tempting to try to spot the precise location of the next financial crisis. Did quantitative easing inadvertently create a safe-asset shortage in the Eurozone? Is the US Treasury market dangerously illiquid? Could Japan’s bond market crash when the departure of Governor Haruhiko Kuroda from the Bank of Japan brings the end of yield-curve control? Alternatively, you can worry about illiquid bonds and loans in the private markets, or the “huge, missing and growing” pile of dollar-denominated debt being held by non-US institutions via currency derivatives, which disquiets the Bank for International Settlements.

Even if there is nothing nasty about to blow up on or near Wall Street with the capacity to cause a systemic crisis, the Fed could still be given permission to cut rates by friendly economists such as Paul Krugman or Olivier Blanchard, who no longer think an inflation target of 2% makes sense. Why not 3%?

The problem with all this is that, during the last inflationary period — the 1970s — the Fed’s behavior was characterized as much by “false dawns” as by pivots from hiking to cutting. In September 1973, when Arthur Burns was chair, the Fed paused hiking for seven months. Financial markets anticipated that a cut would come next, with the 1-year nominal Treasury bond yield rallying from 8.8% in August 1973 to 6.9% in February 1974. However, instead of cutting, the Fed hiked again on April 25, 1974, taking the discount rate to 8%. This caused a reset in rate expectations, sending the 1-year yield to 9.4% by August 1974.

There was a similar sequence in 1979, when a Fed pause and declining 1-year yields were followed by the appointment of Volcker, a series of hikes, and steep losses for fixed-income investors.

According to a number of economic journalists, for example Matthew Klein, the problem for the Fed is the labor market, which remains very tight. The number of workers quitting their jobs for better opportunities elsewhere remains elevated. Payrolls are growing at annual rate of 7%, well ahead of output. And let’s not forget the supply constraints on the labor market: the persistence of Covid as a deterrent to older people who might otherwise rejoin the labor force; or the complete breakdown of our system of legal immigration.

However, I know plenty of economists (at the San Francisco Fed, for example) who doubt that the labor market really is a driver of inflation, as opposed to its being driven by rising inflation expectations. I don’t think it will be the labor market that spoils Powell’s monetary landing on the Hudson.

Let’s take a closer look at what happened in the 1970s. Remember, the “great inflation” of that decade happened in three waves, each bigger than the one before. The first peaked in February 1970 (consumer price inflation 6.4%); the second peaked in November 1974 (12.2%); the third peaked in March 1980 (14.6%). Between the first and second peaks there was an attempt — at first apparently successful — at bringing down inflation. It simply failed. And the same happened again between the second and third peaks. Why?

In his classic history of the Federal Reserve, the late Allan Meltzer offered the best answer. In part, the Fed (and government economists more generally) wrongly assumed that full employment meant an unemployment rate of around 4% and wrongly expected a return to the higher productivity growth of the immediate postwar years. In addition, “policymakers erred in treating the output loss following the 1973 and 1979 oil shocks wholly as evidence of recession, instead of partly a one-time transfer to the oil producers that permanently reduced the level of output. This contributed to the mismeasurement of the output gap and the desire to raise output by monetary expansion.”

To put it simply, the Burns Fed started with a flawed model and then was hit by not one but two geopolitically driven shocks.

The Fed had begun raising the discount rate to combat rising inflation in February 1973, beginning with two consecutive 50-basis-point hikes, followed by a sequence of four such hikes between June and September. Then it paused for seven months.

No sooner had the Fed hit pause than war broke out. Egypt and Syria attacked Israel on Oct. 6, 1973. The price of oil had already begun rising before the war, from $3.56 to $4.31 a barrel in August. But the oil embargo imposed by the Arab members of OPEC more than doubled the price to $10.11 by January 1974. The combination of higher interest rates and higher oil prices caused the worst US recession since the 1930s, which lasted from November 1973 until March 1975. Real output fell 4.9%, industrial production 15%. The S&P index plunged 40%, wiping out all the nominal gains investors had made since 1963. It did not regain its January 1973 level until 1980.

The onset of such a severe recession, you might think, was the cue for the Fed to ease. Certainly, the Boston Fed repeatedly requested a lower discount rate. But the Federal Reserve Board rejected each of its requests. Instead, with only one vote against, the board opted to raise rates in order to (as they put it) “foster financial conditions conducive to resisting inflationary pressures.” On April 25, 1974, the board approved a half percentage-point increase in the discount rate to 8%. The federal funds rate rose from an average of 8.97% in February to 12.92% in July. Yet inflation ended 1974 at a peacetime high of more than 12%.

A version of this process repeated itself later in the decade, with inflation coming down sharply in 1975 and 1976, only to surge to an even higher peak in the subsequent four years. In both cases, a key variable was exogenous. In 1979 it was the Iranian Revolution and the subsequent US sanctions that did the damage.

We have already seen this year how a war — the Russian invasion of Ukraine — caused inflation around the world to surge by disrupting energy and food exports from the warring countries. When the Fed projects that its preferred measure of inflation (the rate of change of the personal consumption expenditures index) will decline this year so rapidly that by the end of next year it will be at most 150 basis points above the 2% target, it is asking us to believe that nothing bad will happen in 2023.

Now there are some years in history when nothing bad happens. One of my favorite book titles is Ray Huang’s 1587: A Year of No Significance (about the decline of the Ming Empire). But how likely is 2023 to be such a year?

Consider the possibility that, as in the 1970s, the Middle East might spring a surprise on us all. This year, leaving aside the World Cup, the big story in the region for most Western media and social media has been the wave of popular protest in Iran that followed the death in custody of Mahsa Amini. This is understandable: It takes immense courage to confront the tyranny of the ayatollahs.

However, these protests are dwindling in the face of brutal repression. According to Iranian opposition groups, more than 15,000 demonstrators have been arrested and over 300 killed. The regime’s security forces remain large, highly indoctrinated and well prepared. They have shown no sign of splintering since the protests began.

Paradoxically, the protests’ primary significance may be to expand the power of the Iranian Revolutionary Guards Corps, Supreme Leader Ali Khamenei’s praetorian guard, and hence to radicalize the regime still further. Publications close to the supreme leader have criticized demands to ease religious law and calls for a new nuclear deal with the West, describing supporters of such policies “ignorant, oblivious traitors” and “instruments of the Zionists and Americans.” The IRGC is also taking the opportunity to push for a “response” to Saudi Arabia’s alleged funding of Iranian opposition media.

Back in June, Saudi Arabia reached a cease-fire with the Iran-backed Houthi rebels in Yemen and launched talks to restore diplomatic ties with Tehran. Both the cease-fire and the talks have since collapsed. Iranian state media have blamed the protests on a “Zionist-Al-Saud media alliance.” So grave did the threat seem last month that on Nov. 1 the Saudis warned the Joe Biden administration of an “imminent” attack, leading US Central Command to scramble fighters in anticipation of a drone strike.

Saudi oil infrastructure is better defended today than it was in 2019, when Houthi suicide drones destroyed a major refinery. However, the Houthis are adept at multilayered attacks that use both drones and ballistic missiles to overwhelm air defenses. Saudi Aramco’s refinery in Jizan, which is close to the Yemeni border and processes 400,000 barrels of oil a day, is especially vulnerable.

I am not alone in seeing parallels between the 2020s and the 1970s. My old friend Ken Rogoff recently warned that “the world may very well be entering an extended period in which elevated and volatile inflation is likely to be persistent, not in the double digits but significantly above 2%,” as geopolitically driven supply shocks combine with Keynesian policies of demand stimulus.

As with the World Cup, the tiniest of margins may prove to be decisive. A matter of inches makes the difference between scoring and hitting the post. In the same way, 25 basis points too many or too few can make the difference between a nasty recession and an inflationary spiral. We shall learn today who is the king of the round ball. How far Powell deserves the title of monetary maestro may not be known for years.

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