Inflation isn’t an illness that can be studied, contained, and cured by data analysis and reasonable actions. It is a perpetual flame (“2% is just fine because deflation is terrible”) that can erupt when conditions are right (i.e., wrong).
Worse, that flame-up awakens human nature-driven responses that add fuel to the fire. At that point, the only “cure” is to throw buckets of sand onto the inferno, stomp the embers, and drench the last sparks in the ashes.
Does that sound silly? It’s not because inflation is not a bad condition that everyone wants gone. Sure, everyone dislikes rising costs. However, businesses like the higher prices, employees like the higher pay, and governments like the higher taxes. Therefore, there are games afoot to take advantage of those rising prices.
It’s like a game of musical chairs. Everyone wants to be the last one to gain before the party ends.
But aren’t the high interest rates doing the job of tamping down inflation?
Nope. First off, the rates (even after the likely 0.25% increase coming) are only back up to the minimum expected level (that is, 0% real). The increases so far simply rectify the Fed’s previous ones kept abnormally low. To conquer inflation, they need to go much higher.
But that’s not all. Other actions need to be taken – particularly, a tightening of the money supply.
Think of what Fed Chair Powell originally said – it takes pain to defeat inflation. That was a correct statement, but the Fed’s actions and comments since then have ineffective. The Fed’s recent pause, small expectations, and waiting for the data to show they’ve done enough is wrong. Instead, they are throwing away their initial results, as is evident by the improved economic, investment, and sentiment data.
Want to see the damage inflation does? Here is the January 1965 view by the Federal Reserve Bank of New York. (Alfred Hayes was president and a member of the Federal Reserve Open Market Committee. He was the leader of the “tight money” faction that favored a more restrictive credit policy than the central bank was pursuing.)
(Underlining is mine)
“Price developments continued to be a cause for some concern in December [1964]. Both consumer and industrial wholesale prices rose slightly in November, and some additional rise in the industrial component of the wholesale-price index apparently occurred in December.
“Moreover, a number of further price rises announced by the steel industry in late December undoubtedly added to the recently emerging climate in which businessmen seem to be less reluctant to probe markets to determine whether price increases can be made to stick.”
And those price rises that stick beget further price rises. That has been obvious in the past many months. When will they stop? Either when the decline in revenues eats into profits or when the economy heads into a recession.
The 1960s show how incomplete Fed efforts promote worse inflation
The graph below shows how the Fed’s actions, if cut short, allow inflation to rise even higher.
It was 1965 when the lengthy inflation period started. The price rises (red line) above the earlier 1% to 2% range were spurred by high economic growth. While the Fed raised the discount rate (blue line) (it was the primary interest rate used at that time), it let the money supply (green line) keep increasing. As a result, around mid-year, inflation began its initial move to new highs – over 2%, then 2.5%, then 3.5%. With another interest rate rise having no effect (except for widespread criticism about the Fed harming the strong economy), the Fed tightened the money supply growth.
From The New York Times (Dec. 11, 1966): “[Federal] Reserve Is Split on the Economy – Differences Seen in System on the Outlook and Course of Monetary Policy – Majority Cites Need to Ease Tight Money; Others Say It Would Be a Mistake”
Sound familiar? The catchphrase that caught on was, “It’s better to err on the side of ease.”
Alas – and here’s the important case study – with inflation starting to trend down as the economy was slowing in its pre-recession period, the Fed prematurely reversed course. It cut the discount rate and allowed the money supply to grow again. As a result, inflation bottomed at the formerly too-high level of 2.5% and started its rise to 6+%. Note, there were no pullbacks this time, even as the Fed increased the discount rate once again.
And then came the key lesson. As inflation increased again, the Fed reversed course again, raising the discount rate again and cutting the money supply growth significantly. The result? Nothing! Business as usual. Why? Because everyone had seen the Fed exit before any real pain occurred, so the party kept going.
(In the fall of 1969, I was doing my 3-month stockbroker training in New York City. Despite the Fed’s efforts, everything was booming and optimism was high. For years after, 1969 was labeled as the best year ever for Broadway plays. As to investing with a high 6% discount rate? Who cares – fixed-income securities were now yielding more as bond prices fell. Therefore, everyone knew that the stock market was the place to be.)
Now look at the 1970 recession, the gray area. Inflation stays up, forcing the Fed to keep the discount rate up. The recession was serious, so, as the inflation rate inched down the Fed reversed course again. Too soon. Inflation (that is, continued price raising) was now baked into the people’s heads and, therefore, the economy.
Then, there is the other problem with significant inflation (like our current 5% level). Businesses look more successful than they really are with rising prices countering slowing or declining unit sales. To see that effect, look at the graph below. It shows the trailing 12-month growth as reported (the higher, blue line). Note that during the 1970 recession, the economy still produced a headline 5+% growth rate. When adjusted for inflation (“real” – the lower, green line), it was 0%. However, all the reporting showed the higher, unadjusted growth. (“Growth in a recession? Way to go! Here’s your bonus and raise.”)
The bottom line: If the Fed doesn’t shock us on July 26, prepare for the return of a lengthy inflationary period
How could they shock us? By making three announcements:
- The Federal Funds rate is going up significantly -like to 6%-, and it will probably keep increasing until inflation is significantly lower
- The Federal Reserve bond holdings (i.e., excess money supply) will be decreased by a significant amount (like $1 trillion) by year-end
- The Federal Reserve is committed to a much lower inflation rate and realizes that getting there will involve negative adjustments for many. However, it’s the only way to preserve the U.S. dollar’s value and protect all those who are harmed by inflation.
Think that will happen? Hope for the best, but prepare for another painful, “that’s good enough,” history lesson.
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