22 Sep 2022
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Mark McDonnell, Macro Analyst
A decade of disco, flares and inflation
It’s not just 1970s fashion that has made a comeback. Today’s environment of weak growth and high inflation is reminiscent of the 70s too.
Lessons from the past
We look back at Arthur Burns and Paul Volcker’s stints chairing the Federal Reserve. There are some key lessons on how to deal – and not deal – with inflation.
The moral of the story
Price stability is the bedrock of a healthy economy. If inflation gets embedded, you can no longer trade off a stronger labour market for a bit more inflation.
The 1970s was a period synonymous with weak growth and high inflation or, in economist speak, stagflation. The period was also a perfect case study of how to deal – and not deal – with high inflation. Having graduated in 1975, Chairman Powell would have undoubtedly followed developments closely – and it will be top of mind as the Fed attempts to deal with a familiar foe.
Inflation hangover: McChesney Martin’s failure to ‘remove the punch bowl’
It’s unfair to lay all the blame on the then Fed chair, Arthur Burns. He inherited an overstimulated economy, caused by President Johnson’s deficit spending from the Vietnam War and Great Society programmes.
Burns’ predecessor – William McChesney Martin – also acknowledged his role in creating the problem. In 1955, McChesney Martin famously said it was the Fed’s job to ‘remove the punch bowl just when the party was really warming up’. By his own admission, however, the advice wasn’t always heeded. In his valedictory speech he said:
Arthur burned by external shocks and bad policy
Burns was also a victim of external shocks and bad policy.
Firstly, on 15 August 1971, Nixon suspended the convertibility of the dollar into gold. Up until this point, the Fed had kept the dollar’s value at $35 per ounce. By April 1974, it shot up to $143 per ounce. Over the same period the broader dollar index (DXY) fell by nearly 20%.
Secondly, Burns was a victim of bad policy decisions made by Nixon when he, unsuccessfully, sought to address inflation by imposing a series of wage and price controls.
Thirdly, there were two oil shocks. The first was in 1973 when OPEC embargoed oil sales to the US for supporting Israel during the Yom Kippur War. The second was in January 1979 during the Iranian Revolution. Together, the two oil shocks caused West Texas crude oil to soar from $3.50 during July 1973 to a peak of $40 in 1980.
Monetary policy also played a role. Due to the nature of the shock, Burns doubted the Fed had the power to control inflation. Instead, he blamed it on energy prices and the power of labour unions. This led to a bias towards prioritising low unemployment at the expense of a little inflation.
A useful illustration was the Fed’s reaction to the 1973 recession. Before the recession had even ended, the FOMC had started the easing cycle – cutting the federal funds rate seven times between December 1974 and November 1976. Although this was a conventional response under normal conditions with stable inflation, it is now widely agreed that it was too soon to bring down inflation.
Carter steps in to tackle inflation
The turning point came in the late 1970s when President Carter announced a series of measures to tackle inflation.
Firstly, he sought to stabilise the dollar with the dollar rescue package. This included sales of gold, borrowing from the IMF and auctioning treasury bonds in foreign currency. The policy worked and the broader dollar index appreciated by around 60% between 1978 and 1984.
Of course, monetary policy was also a factor. The big shift here was Carter’s nomination of Paul Volcker in 1979. Only a few months into the job, Volcker said he would focus on restraining the growth of the money supply. By the late 70s – despite a relatively weak growth backdrop – the Volcker-led FOMC had pushed the fed funds rate to a record high of 20% and the economy slowed markedly.
At this point, the FOMC started to experience widespread public criticism. Farmers protested at the Federal Reserve’s headquarters, and construction workers mailed 4x2 wooden blocks to the Fed. They argued that Volcker’s stance was destroying the industry, so they had no better use for the lumber. Despite further criticism from politicians and the wider public, the Fed held its nerve.
The moral of the story
Burns’ experience is a poignant reminder that price stability really is the bedrock of a healthy economy. If inflation gets embedded in the economy, you can no longer trade off a stronger labour market for a bit more inflation.
The key lesson from Volcker’s tenure is perseverance. Although PCE inflation peaked in 1980 at 11.6%, the Fed waited years before they backed away from tight policy. By this point, PCE inflation had halved and unemployment was in double figures. Moreover, the US had experienced two recessions – one short recession between January and June 1980 and a longer lasting recession between July 1981 and October 1982.
Four years into his tenure, Chair Powell is no doubt thinking about his legacy and the shape the Fed will be in when he hands over the reins. In my mind, former NY Fed President Bill Dudley succinctly sums up the lesson for Powell in a recent Bloomberg op-ed: