The Fed Isn’t Bluffing: The Real Threat of an Upside-Down Depression

“Soon after October 6, 1979, [US Federal Reserve chair Paul Volcker] he met with some CEOs of medium-sized companies. . . . One CEO announced that he had recently signed a three-year employment contract with annual salary increases of 13 percent, and was happy with the outcome. Only bitter experience would purge inflationary expectations and behavior. “Credibility” had to be earned through suffering. This was essentially the Volcker program. — Robert J. Samuelson, The great inflation and its consequences

Will the US Federal Reserve abandon its aggressive contractionary monetary policy once markets begin to capitulate? Many investors expect it. But given the fundamental conditions at stake, it would be wise to dispense with such fantasies. The Fed is unlikely to abandon policy prematurely. This means we must prepare for economic pain worse than any we have experienced in the past decade.

To understand why the Fed is unlikely to back down, we must first understand the severity of the threat.

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An inverted depression

The United States has experienced periods of high inflation lasting more than a year only six times since 1800. In all but one case, the main driver was a full military mobilization or the immediate aftermath of such a mobilization. This, of course, was intentional: wars are easier to finance by printing money and debasing currency than by raising taxes.

So what was the one obvious exception to this pattern? The Great Inflation of 1968 to 1982. Flawed monetary policy was the clear culprit here. A misguided Fed succumbed to pressure from politicians in both parties who favored reducing unemployment over price stability.

US inflation rate, 1800 to 2020

Chart showing the US inflation rate, from 1800 to 2020
Source: Federal Reserve Bank of Minneapolis

The Fed’s flawed philosophy during this era can be traced back to the concept of the Phillips curve. Economists of the time believed that there was a stable trade-off between inflation and unemployment and that lower unemployment could be achieved in exchange for slightly higher inflation. But what Phillips Curve proponents failed to understand is that while there was compensation, it was only temporary. When unemployment fell below its natural rate, it established a new baseline of expected inflation, and unemployment rates eventually returned to previous levels. The Fed would loosen monetary policy again when unemployment rose and inflation rose ever higher. In pursuit of unsustainably low unemployment, the Fed created a vicious circle: the country suffered both of us high unemployment and high inflation, or “stagflation”.

this depression in reverse it was as painful as a deflationary depression, but it came with a lingering one to increase in prices rather than a fall. This was the fundamental dynamic underlying the Great Inflation.

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Few who lived through the Great Inflation have fond memories of its economic effects. From 1968 to 1982, the United States experienced four recessions. High inflation dragged down real wages: workers had bigger paychecks but less purchasing power. Home loans and business loans grew increasingly unaffordable as lenders raised rates to offset higher inflation expectations.

Meanwhile, stock returns were abysmal. Investors demanded higher returns in relation to rising interest rates and price-to-earnings ratios plummeted. Price instability slowed business investment and operational efficiency, leading to a sharp decline in productivity. The hopelessness was reminiscent of the Great Depression. The poverty index, which adds up the inflation rate and the unemployment rate, confirms this. During the Great Inflation, the metric was not far off from where it had been during the Great Depression, averaging 13.6% from 1968 to 1982 versus 16.3% during the 1930s.

US Poverty Index, 1929 to 2021

Chart showing the US poverty index, 1929 to 2021
Sources: US Poverty Index; Federal Reserve Bank of Minneapolis; Labor Statistics Department
The official poverty index begins in 1948. The unemployment and inflation data used to calculate the pre-1948 metric use a different methodology. However, the overall trend is likely to be directionally correct.

The messages from the politicians made the situation worse. They refused to question their economic assumptions and instead blamed inflation on exogenous events such as oil embargoes and the Vietnam War. However, when these shocks subsided, inflation persisted. Retrospective analysis of this event revealed that these were not significant causal factors; they only increased inflation at the margins. The main cause was a persistent and overly accommodative monetary policy.

It was only when Volcker, backed by President Ronald Reagan, began his relentless campaign to reduce the money supply that the Fed restored its credibility and finally ended the Great Inflation. Of course, Volcker’s campaign was not without cost. The nation suffered a terrible recession from 1981 to 1982, as the federal funds rate peaked at 20% in June 1981 and unemployment at 10.8% in 1982. The country paid a high price for 14 years of monetary nonsense. It’s not something US central banks will easily forget or repeat willingly.

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Preventing depression in reverse

The Fed’s current leadership deserves some empathy for the challenges it has faced since the start of the COVID-19 pandemic. First, in March 2020, with the help of substantial fiscal stimulus, it avoided a second Great Depression, and now, just two years later, it must counter a possible second Great Inflation. And preventing the latter in 2022 is just as important as preventing the former in 2020, even if the countermeasures are precisely the opposite. Giving people more money prevented a return to the 1930s; avoiding a return to the 1970s will require taking out money.

The Fed is already taking a step back. It certainly misjudged the persistence of post-COVID-19 inflation late last year. Therefore, more draconian policies may be required to compensate for past mistakes. And time is running out. The longer inflation persists, the more expectations will shift upwards and the higher the cost of reversing the inflationary spiral.

Future perspectives

Make no mistake; the Fed knows why the Great Inflation happened and how painful a possible repeat would be. He will do whatever it takes to prevent such a catastrophe.

There is no absolute certainty in investing. Human beings are fallible and economic factors are unpredictable. But it would be unwise to bet against the Fed’s sincerity in this case. Rather, we should prepare for monetary tightening that will persist until prices stabilize. This scenario is hard to imagine without a painful recession and further market declines.

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Volcker restored the Fed’s credibility in the early 1980s through suffering. The Fed of 2022 knows it must follow a similar course today. Although suffering is inevitable, it is impossible to know precisely when and to what extent it will be. Indeed, those speculating should remember Volcker’s admonition:

“There is a wise maxim of the economic forecaster’s trade that is too often ignored: pick a number or pick a date, but never both.”

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All posts are the opinion of the author. Therefore, they should not be construed as investment advice, nor do the views expressed necessarily reflect the views of the CFA Institute or the author’s employer.

Image credit: ©Getty Images/P_Wei

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Mark J. Higgins, CFA, CFP

Mark J. Higgins, CFA, CFP is a seasoned investment advisor with over a dozen years of experience serving large institutional investors, including endowments, foundations, public pension plans and corporate operating reserves. He is also an avid financial historian and is publishing a book on the complete history of the American financial system in early 2023 with Greenleaf Book Group. Higgins received a Master of Business Administration from the Darden School of Business and graduated Phi Beta Kappa from Georgetown University with a Bachelor of Arts in English and Psychology. He is also a CFA holder and a CFP professional.

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