The Inflation Game: War, Peace, and the Perils of Central Banking

“The decline is always more sudden than the increase; a balloon that has been punctured does not deflate in an orderly manner”. – John Kenneth Galbraith

I traveled with my family to London and Normandy, France in July 2022. The main purpose of the trip was to meet up in Normandy with my father-in-law, who had always dreamed of visiting the places where the tide turned during the Second World War. . I didn’t realize that our excursion would have such relevance to today’s economic conditions.

On September 21, 2022, the US Federal Reserve stepped up its attack on inflation with its third consecutive 75 basis point hike in the federal funds rate. The Fed also warned that further monetary tightening was coming and would continue for at least next year.

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Threading the needle on Threadneedle Street

The Fed is in a difficult position: it must prepare the public for impending economic pain but not cause panic. The reality, however, is that a recession is now a virtual inevitability. Because? Because the Fed can only use strong policy tools to reverse what have become extreme economic conditions. This makes it extraordinarily difficult to engineer a soft landing. The last two comparable events, the tightening cycles of 1920 and 1979 to 1981, led to severe economic contractions.

During our visit to London, my son and I visited Threadneedle Street and the Bank of England Museum, where we played the inflation game. The goal is to balance a steel ball at the midpoint of an air tube marked with a 2% inflation marker. The player, or an annoyed parent, presses an “economic shock” button that shakes the tube, dislodging the ball and sending it to the far right, representing inflation, or to the far left, representing deflation. My son struggled to get the ball back on target, overshooting several times before getting it to settle at 2%.

Image of the inflation game at the Bank of England Museum
The Inflation Game at the Bank of England Museum
Image courtesy of Mark J. Higgins, CFA, CFP®

The inflation game is a perfect metaphor for the Fed’s situation since the start of the COVID-19 pandemic in March 2020. First, the massive economic shock got the ball rolling to the left. The Fed and the federal government responded by flooding the economy with liquidity to avoid extreme deflation and a possible depression. Then in 2022, after excessive stimulus had moved the ball too far to the right, causing high inflation, the Fed reversed course. It will almost certainly exceed the target again, only in the other direction, before it can perfect a return to the comfortable 2% target.

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The human costs of the Great Depression

This monetary tightening will have consequences: the ball has simply moved too far from the midpoint. This will produce economic pain in the form of declining asset values, job losses and general anxiety about the future. This does not mean that the Fed takes its responsibility lightly. The Fed leadership knows that its policies will cause short-term pain, but it also knows that the long-term consequences of policy mistakes—or inaction—are much more serious.

This brings us to the second stop on our trip: Normandy, France. That World War II broke out less than 10 years after the start of the Great Depression is no coincidence. By 1929, the Nazi party was on the verge of collapse. The German economy was recovering from the devastating hyperinflation of the early 1920s, and a new optimism was taking root. In the 1928 elections, the Nazis won only 12 of the 491 seats in the Reichstag. But then came the Great Depression. Millions of Germans joined the ranks of the unemployed, and the economic decline seemed bottomless. In the September 1930 elections, the Nazis won 107 of the 577 seats and set about dismantling the Weimar Republic.

It’s worth remembering the experience of the 1930s and 1940s. When central banks flood the market with liquidity to prevent a Great Depression-level event, their primary goal is not to prop up stock prices but to save lives. Would World War II, and all its horrors, have happened without the Great Depression? Probably not. Could similar disasters have unfolded in 2020 or 2008 if central banks and government policymakers around the world had failed to stop the panic? It’s a different possibility.

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The misery of the great inflation

The dislocations of the Great Inflation from the late 1960s to the early 1980s led to similar levels of deprivation in the United States. The poverty index, which adds up the inflation rate and the unemployment rate, reflects this. During the worst years of the Great Inflation, poverty index readings were almost as bad as during the Great Depression. The average poverty rate during the peak period of the Great Inflation from 1968 to 1982 was 13.6%, compared to 16.3% during the 1930s.

The US Poverty Index, 1929 to 2021*

Chart showing the US poverty index, 1929 to 2021
sources: Federal Reserve Bank of Minneapolis, Department of Labor statistics
*The official poverty index begins in 1948. The unemployment and inflation data used to calculate the poverty index before 1948 are based on a different methodology. However, the overall trend is likely to be directionally correct.

History shows that economic suffering breeds popular discontent, which in turn breeds civil unrest and violence. This is what happened in the midst of the Great Inflation of the late 1960s and 1970s in the United States. In fact, the misery of the Great Inflation was even more insidious than that of the Great Depression. An economic collapse is easily understood as a source of suffering. The debilitating anxiety caused by constant price hikes is harder to understand. It took the foresight and courage of Paul Volcker to add to the pain temporarily to curb inflation in the long run.

Sympathy for the Fed

The Fed and other public officials are easy to criticize, but I believe they take their responsibilities seriously and understand that their decisions affect the lives of millions of people. His swift action in response to the pandemic prevented the American economy from plunging into another Great Depression. Their current efforts are aimed at countering a repeat of the Great Inflation. Neither the Great Depression nor the Great Inflation is an event that no one would want to repeat.

Over the next year, there will undoubtedly be more pain before the US economy returns to a sense of normalcy. And even when it does, new challenges will arise. I’m crossing my fingers that the Fed will somehow thread the needle and orchestrate a soft landing. But if he fails, it won’t be because of personality flaws or professional incompetence. It will be because of the near impossibility of the task. Instead of blaming the Fed for the pain we’re likely to experience in the near term, we need to keep our eye on the ball and remember that getting inflation back to the 2% target is our highest priority.

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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 courtesy of the Print and Photograph Division of the Library of Congress/Original drawing by Edmund S. Valtman.

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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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