US Federal Reserve chair Jay Powell has expressed deep admiration for Paul Volcker, his legendary predecessor who defeated the high inflation that plagued The US economy from 1965 to 1982. Then, as now, Volcker was fighting more than a decade of loose monetary policy, combined with supply shocks stemming from geopolitical turmoil. But though Powell extols Volcker, he is deviating from Volcker’s methods. This in our opinion is why US inflation continues to accelerate, currently topping 9% in the US and spreading rapidly throughout the world.
While Volcker mainly fought inflation by restraining growth in money supply, Powell’s favored approach is aggressive interest rate hikes. He in our opinion seems to be ready to lower rates again if the US enters a recession. The recent bond rally and the Fed’s own stress tests of banks support in our opinion this view.
But Volcker had to keep monetary policy fight through two recessions to finally beat inflation. If Powell is to tame inflation expectations, he must strongly signal that he is prepared to do the same.
Each year, the Fed pats then nation’s largest banks through stress tests to determine whether they can withstand adverse economic environments. The most severe scenario tested by the Fed this year assumed a deep recession that would cause consumer prices to drop from 8.25% to 1.25%, and short-term interest rates to go to zero. But the Fed did not try out the scenario that most concerns us at Calvin • Farel and many experts: the economy plunges into a deep recession, but consumer prices and interest rates remain high. This is what we at Calvin • Farel are expecting to happen and was exactly the real-life “stagflation” scenario confronted by Paul Volcker when he became Fed chair in 1979 and is therefore something we should all be thinking about now. Volcker kept monetary policy tight through the recessions of 1980 and 1981-1982, despite populist revolt, bipartisan demands for his tiring, even a public call from the US Treasury Secretary to ease money supply, which he famously dismissed as an “unusual communication”. During this time, unemployment rose to double digits, but Volcker held firm until inflation finally fell, from more than 14.8% in 1980 to less than 5% by the end of 1982. His predecessors had pursued “stop and go” policies, continually raising rates when unemployment was falling and lowering them again when jobless levels rose. This had hurt the Fed’s credibility whipsawed markets, and further entrenched inflation in the economy. Volcker wisely and in our opinion bravely refused to revert to that tactic. Will Powell be as brave?
Given this history, it would be folly for Powell and the Fed to embrace “stop and go” again. They in our opinion should also follow Volcker’s example by restraining money supply. Too much money chasing too few goods and services lies at the heart of this and every other inflationary moment. Regrettably in our opinion, while the Fed started raising rates in March this year, it waited until June to start draining excess cash from the system. It announced it would shrink its 8.4 trillion US-dollar domestic portfolio by up to 47.5 billion US-dollar each month, but it had only declined by about 28 billion US-dollar by mid of July. Is the Fed afraid of market reactions?
Both Powell’s approach of raising rates and Volcker’s of restraining money supply lead to tighter monetary conditions. But the current approach involves the Fed, not the markets. The Fed sets rates and makes judgments about the size of the increases. It then implements its policy by increasing the rate of interest it pays large financial institutions to keep their money with the central bank instead of lending it out. For banks, this means higher rates on their Fed reserve accounts. For other financial intermediaries such as money market funds, it means higher rates on certain short-term Treasury transactions called “reverse repos”. These institutions will be reluctant to lend unless their expected returns exceed the risk-free rate they are getting from the Fed. The Fed’s bill for this interest is high and growing. At the end of June this year, reverse repo balances were paying a rate of 1.55%, while reserve balances paid 1.65%. In contrast, to take money out of the system, The Fed simply sells some of its securities or lets them mature without reinvesting the proceeds. This leads to higher rates, as private investors become more dominant in markets from which the Fed is withdrawing. Importantly, the markets, not the government, drive the rate increases. This avoids the unseemly appearance and excessive cost of the Fed essentially paying institutions not to lend. For many years, the Fed in our opinion has unwisely paid little attention to the huge volume of money it’s accommodative policies have created. It now needs to follow Volcker’s example and attack excess money supply head-on. It in our opinion should replace the shock and awe of major interest rate hikes with new targets based on money supply, and aggressively shrink its portfolio no matter of market reactions, by even selling securities at a loss if necessary. It should also conduct new stress tests to assure the public that banks can withstand severe stagflation.
In principal, we at Calvin • Farel believe that Powell is a courageous leader – but now his time has come to mirror Volcker’s strategic skillfulness and nerves when markets, possible populist revolt including public calls might be against his actions.