Q:”The Debate on Wall Street: Did the Fed Pivot Too Soon?” (The New York Times
NYT
– Dec. 15)
A: Yes. Here’s why…
Powell’s promised pain to defeat inflation is now forgotten. In its place is “soft landing” happiness that repeats the Federal Reserve’s serious 1966 mistake. Understanding what then happened provides an investment guidebook for today.
First, how to properly view today’s inflation situation
Inflation (CPI-All items) is now up 18% in only three years – an abnormally fast increase. The Fed’s portrayal of mostly-tamed inflation is based on only the past twelve months. However, while that lower short-term number is praised, the cumulative damage continues to compound higher. It’s the answer to the NPR “Weekend Edition” question, “Inflation has cooled a lot. So why do things still feel so expensive?” Prices are not stabilizing, much less going down. They continue to rise ever higher.
In other words, a “low” 3% inflation rate in 2024 does nothing to offset the damage done from 2021 through 2023. Instead, it would compound that accumulated 18% up to 21.5%. The Fed’s illogical conclusion is like examining a car that was seriously damaged in a 2022 crash and saying that getting only two dents in 2023 means the car is fixed.
(See my Sept. 2023 article for more explanation: “U.S. Inflation Cycle’s Damage Is Worsening.)
The Fed’s fatal flaw: Ignoring human nature’s history
Despite the Federal Reserve’s comforting statements and lower-interest-rate teases, inflation’s drivers remain. However, reality has shifted to higher risk:
The Fed’s reassurances mean investors and consumers believe inflation fears now are alleviated. And that means…
… when the still-active inflation drivers cause the next flare up, human nature’s altered attitude will kick in. Instead of concern, it will produce only a tepid “been there, done that” response. Therefore, any future Fed warnings and “fight inflation – again” actions will prove ineffective. It happened in the late 1960s, and human nature has made no evolutionary improvements since then.
Note: Okay, now you know the point of this article. The historical proof discussed below takes longer to explain, so if you don’t have the time or interest, I’ll understand. Just know that the 1966 incident happened with a wiser, more experienced Fed Chair at the helm amid conditions that were better and more normal than currently exist. And yet, the fiat money inflation beast still arose and went on a tear.
Understand 1951-1969 history to see what’s coming
In late 1965, an excellent economy growth period, Fed Chair William McChesney Martin Jr. (his father helped create the Federal Reserve) was in charge. His term, 1951 to 1970, remains the longest. His background was uniquely comprehensive, and his approach combined wisdom, common sense and the courage to take necessary but unpopular actions.
The period 1953 (the year the Korean War ended) through mid-1966 provides an excellent view of how well the Fed supported and tweaked the monetary system. Of the many economy and financial measures, the ones shown below are particularly key:
Economy growth rate (two green lines) — GNP: Gross National Product (GNP) 12-month periods for both nominal and real (inflation-adjusted). (Economists would shift preference much later to GDP: Gross Domestic Product, but the two measures are very similar.)
Inflation rate (orange line) — CPI: Consumer Price Index (All items) 12-month periods. (The “Core” CPI [All items less food and energy] would start to be reported in 1975 following 1973’s unusual food and energy rises that pushed the All-Items inflation rate abnormally high.)
Discount rate (blue line) — Among the Federal Reserve’s tools, the discount rate was the primary observable one at this time. Years later, there would be a switch to using the Federal Funds rate. Both had the same effect.
Note: I know many of you will find the coming graph daunting. I’m breaking presentation rules, by showing more than two lines and covering an overly long period. However, I have winnowed down both the number and length to a minimum. Taken together, they show the timely actions taken to limit inflationary runups and to prevent extended economy recessions.
Important: There are four visible accomplishments in this graph:
Good discount rate timing: Raises and reductions generally occurred in response to or in anticipation of undesirable economy growth or inflation rate shifts
Low inflation rates: The goal was low. Note that zero and negative were accepted as fine – not presented as scary indicators of a deflationary depression as Ben Bernanke did
Stable inflation rates: Hard to achieve, but nevertheless the other goal. The idea is that low, stable inflation provides the best environment for everyone
Recessions were contained: Negative real GNP growth was “achieved,” but limited and short-lived. Thus, high growth excesses were offset before a boom-bust swing occurred
Now to the timely, courageous, December 1965 rate increase
The year 1965 was a great year for the United States economy. The major companies were performing especially well, with GM leading the world business parade. The blue-chip stock market was on a tear, the U.S. government’s actions for President Johnson’s Great Society was moving forward, with unemployment low and financial conditions sound. In December, the outlook for 1966 was sunny and Johnson was putting together his coming State of the Union speech.
However, the good times were becoming worrisome to some. From The New York Times Sunday, December 5, “The Week in Review” came, “Brakes Are Urged for Fast-Moving Economy, but U.S. [Government] Keeps Foot Off.” So, that morning, people read,
“Almost everywhere – in the business world, in banking, in economic circles and even on Wall Street – a consensus seems to be forming that the times has come for the Government to apply some brakes to the fast-moving economy.
“Apparently, however, that view is not widely held in Washington. Administration officials continue to adhere – at least publicly – to the line that the danger point has not yet been reached and that prosperity-without-inflation can linger a good while longer.
“Nevertheless, the signposts clearly indicate otherwise. Pressures on prices, wages, interest rates, the skilled labor force and supplies of certain goods have intensified so significantly in recent months that the nation’s balanced and orderly 58-month expansion is now threatened by serious distortions.
“The remedy that many economic observers suggest – and one that the Administration steadfastly rejects – is a moderately tighter monetary policy.”
Then, wham! That same day, the Federal Reserve announced that the discount rate was going up from 4% to 4.5% to combat inflationary pressures (even though the CPI had yet to rise materially). That surprise action ignited a war of words between Fed Chair Martin and President Johnson. But, importantly, the move was well timed and produced constructive results.
Here are three relevant articles from The New York Times:
4 1/2% DISCOUNT SET – Increase Made in Move to Stabilize Prices — Impact to Vary
“The Federal Reserve Board, defying President Johnson, announced today an increase in the discount rate from 4 per cent to 4 1/2 per cent.”
President Thinks Agency Moved Without Full Facts
“President Johnson said that he was particularly unhappy at this action because it had been taken, in his view, prematurely. He said he would have preferred the board to have postponed its vote until the ‘full facts’ had been assembled on the outlook for the economy next year.”
Martin Defends Rise in Bank Rate – Reserve Chief Argues That General Action Against Inflation Was Needed
“Mr. Martin defended his board’s action with the primary argument that there was urgent need for ‘general rather than selective measures to help counter price pressures at home as well as to help correct our payments imbalance.'”
“A major reason for increasing the discount rate at this particular time, he said, was to ‘act against inflationary pressures when they are in the development stage – before they become full-blown and the damage has been done. Precautionary measures are more likely to be effective than remedial action.’
“Allowing inflationary pressures to build up could accelerate economic expansion to a dangerous pace, he said, and ‘then it becomes necessary to reduce the speed, and once such a reduction is started, there is no assurance it can be stopped in time to avoid an actual downswing.'”
Now to the 1966 mistake
The flip side of waiting too long is acting too soon.
The usual pattern is the economy moves first and then comes the inflationary effect. Somewhere in there, the Fed needs to act to subdue the pressures before a strong, adverse trend develops – either up or down. After seeing the timely discount rate changes from 1953 through 1965, here is the 1966 mistake – a too-early drop in the discount rate.
Note that the economy growth was declining but was still well above the negative recessionary area – just like today. And yet Martin decided to reverse his previous year’s discount rate increase. That was great news to businesses and Wall Street. So, the economy’s growth stabilized, then began to rise again. Wall Street entered a dramatic period, with the “go-go” speculative stock market and widespread investment banking activities as the conglomerate craze ballooned.
As shown in the graph, the Fed was then put in the ineffective position of chasing the once-again rising inflation, now up to new heights. The year 1969 revealed the human nature problem. Inflation (and interest rates) were hitting new highs, the economy’s growth was slackening, the stock market was waffling and yet investor and consumer optimism was rampant. After all, that soft-landing 1966 combined with those exciting years that followed “proved” inflation was not a problem and good times were here to stay.
Then, in January 1970, President Nixon replaced Martin with Arthur F. Burns. When the 1970 recession barely touched negative economy growth, the Fed dropped the discount rate steadily, the inflation rate (and interest rates) started up again, and Wall Street excitedly produced a new growth era, highlighted by the “Nifty fifty” stock market that chased the supposedly best “forever” growth companies. Price/earnings ratios for the favored broke records because the belief was that these companies would produce excess earnings (capital), thereby sustaining their excellent growth records.
Then, it all fell apart, with the terrible 1973-1974 bear market culminating in strong beliefs that a depression was coming. The following Federal Reserve History article describes how Fed Chair Burns fared during this period and the years that followed (he served two terms, from Jan. 1970 to Mar. 1978).
“Burns assumed leadership of the Federal Reserve during the middle of what would later become known as the Great Inflation (1965–82). In short, easy monetary policy during this period helped spur a surge in inflation and inflation expectations. When inflation began to rise, policymakers (in retrospect) responded too slowly, leading to a recession. Inflation was exacerbated by several adverse economic factors during the decade: the administration’s wage-price control program that artificially held down inflation, oil and food price shocks, and government fiscal policies that stretched economic capacities. As Burns later reflected, ‘In a rapidly changing world the opportunities for making mistakes are legion.’”
The bottom line: It’s not misread data that causes problems – It’s misunderstood or ignored human nature and unforeseen effects
So why, you ask, is today’s Fed not showing William McChesney Martin Jr.’s understanding, wisdom and courage – and, particularly, not focusing on his key mistake as an important lesson? Because the FOMC members are too young (1966 was 57 years ago), too inexperienced in Wall Street’s ways (a rising stock market is not an indication of a wise Fed decision), and too dismissive of the human nature effect (the flaw of much academic/economist thinking).
Then there is the general overreliance on past data, along with little or no consideration of the unforeseen. For example, in the first nine months of 1973, the 12-month CPI rate had risen from about 4% (already up from about 2-1/2%) to 7.5%, with the Fed pushing the discount rate up in tandem.
Then, in October, OPEC imposed an oil embargo on the U.S. and other Israel-supporting nations. Up went the CPI, but the Fed was trapped, forced to leave the discount rate unchanged as the inflation rate rose further (needs higher discount rate to fight) and the economy’s growth rate fell (needs lower discount rate to support). The inflation rate topped out at 12+% in late 1974, with real GNP growth rate in negative territory. Human nature also had shifted – to panicky visions of an inflationary depression in the making.
