We Should Cheer Inflation Fighter Jay Powell
Wall Street knows better.
Stock traders went crazy over the past few days because Federal Reserve Board Chair Jay Powell took a firm stand on raising interest rates until inflation begins to fall to the bank’s target rate of two percent and stays there.
The markets should welcome that news instead of responding as if a panic was afoot. Powell’s remarks in Jackson Hole, Wyoming suggest that the Fed won’t repeat the mistakes of the 1970s that made controlling inflation seem like a visit to a dentist who pulls out one tooth at a time looking for Mr. Tooth Decay.
US Federal Reserve chair Jay Powell and Bank of England governor Mark Carney in Jackson Hole, Wyoming, on Friday ©Reuters
Since Powell’s remarks, the markets slashed in half the S&P 500 rebound from its’ mid-June low on fears that rising rates will trigger a recession. Stocks fell throughout the week.
To my mind, there’s little doubt that a downturn probably will occur. Moreover, the Fed faces a tricky path in steering the economy back to solid ground. But the tightrope that the central bank now walks is much better that reverting to the “stop-go” policies that gave the nation a stubborn bout of inflation cured only by blistering back-to-back recessions in 1979-82.
I covered the fight against inflation during the late 1970s and 1980s, much of the time as the chief economics correspondent in Washington for the Chicago Tribune. The Fed had put its muscle behind the Philips Curve — a theory that the central bank could lower unemployment by tolerating high inflation to goose the economy.
When the Fed wanted the “go” side of the curve, it lowered interest rates to ease up on money supply and cut unemployment. When inflation rose, the bank raised interest rates to slow down the economy and reduce inflationary pressures.
But the Phlliips Curve seemed more like a roller coaster than an arc. As unemployment rose, the Fed often bowed to intense pressures to inflate the economy and cut the politically sensitive jobless rate.
When the stop and go cycles whipsawed the economy, investors lost confidence in the central bank’s commitment to price stability. A stubborn streak of inflation soon surfaced, infecting the economy with the psychology of inflation, the thing the Fed really fears. Americans simply started buying now and paying later with cheaper dollars diluted in value thanks to rising prices. The mindset sunk its teeth into the economy and wouldn’t let go.
Finally, the late Paul Volcker came along as the Fed Chair and abandoned the Phillips Curve. In October 1979, he initiated a tight anti-inflation money policy that triggered two recessions.
Volcker’s action exposed how durable the inflation mindset could be once it became embedded in economic thinking. He tightened the money supply and jacked up interest rates. But inflation marched on, rising to nearly 14 percent by mid-1980. Unemployment soared, too, eventually reaching more than 10 percent, a post-World War II high. Ditto Interest rates. The Fed’s benchmark rate, that Powell will probably raise to 3.5 percent in September, reached 20 percent under Volcker.
Like his predecessors, Volcker faced intense pressure to ease off and goose the economy. But he didn’t buckle. He remained a committed inflation fighter, vindicated when rising prices eventually fell to 3.4 percent when he left office. Long term interest rates also declined eventually. But Volcker’s victory had a price: two recessions and hard times for years.
The question now before Americans is will Powell follow Volcker’s lead and trigger a recession?
I doubt stable prices will return without a recession. But there are some big differences between the economy that Powell faces and the one that made people put Volcker’s face and name on wanted posters.
Powell is working with far different numbers. When Volcker started his policy change, unemployment stood at about 7.5 percent. The Fed’s benchmark rate averaged 13 percent for the year and inflation reached 13.5 percent.
photo by Lo Lo
In contrast, unemployment is now 3.7 percent; the Fed’s benchmark rate is 2.25 to 2.5 percent with additional increases to come. Inflation is now 8.5 percent, although it cooled off a bit, particularly under the personal consumption gauge preferred by the Fed.
Another difference is the workforce. Employers report a shortage of workers, which could lead to wage increases, a key factor in inflation. But another workforce change from the Volcker era could really test Powell’s resolve.
In 1982, goods producers (mainly manufacturers, construction, and auto industries) accounted for 30 percent of total employment but suffered 90 percent of job losses in 1982. Goods producers borrow a lot of money to fund operations and are more vulnerable to interest rate increases. Now they account for only about 20 percent of the workforce with services approaching 80 percent.
In effect. Volcker got more bang for his pivot when he veered away from the Phillips Curve. His policies hit goods producers hard, particularly their employees who had relatively well-paying jobs at the time. His policies helped created the shuttered factories that gave America the Rust Belt.
Powell’s Fed will have to put more muscle into service sector cuts. The service segment has many lower paying jobs and it not as capital intensive as the goods producers. That could prove to be a huge challenge.
What does all of this mean? Powell’s Fed may have to extend interest rate increases further than the central bank thinks to slow things down and moderate price hikes. In other words, America may be in for a longer — but less severe — recession than the Volcker calamity.
Yet the biggest mistake the central bank could make is embrace the “stop and go” mentality of yesteryear. Many economists argued that Volcker didn’t have to trigger such a deep recession to get what he wanted. That’s a fair point. But Jay Powell committed the Fed to fight inflation over the long haul. That may not sound like good news, but it’s better than grappling with the Phillips Curve, despite Wall Street’s reaction.
—James O’Shea