The Fed Leadership Believes this Time is Different
Will monetary easing ensure a soft landing or merely reignite inflation?
“The 4-1/2 percentage point decline in inflation from its peak two years ago has occurred in a context of low unemployment—a welcome and historically unusual result.”
—JEROME POWELL, chair of the Federal Reserve Board1
On August 23, 2024, Jerome Powell, chairman of the Federal Reserve Board, delivered a much-anticipated speech at the Fed’s annual symposium in Jackson Hole, Wyoming. The speech provided an opportunity for Powell to signal whether the FOMC intended to pivot toward monetary policy accommodation at the FOMC’s September 17-18 meeting. Chair Powell left little doubt as to the prevailing sentiment. The most revealing moment occurred when he emphatically declared that “the time has come for a policy adjustment.” Absent a dramatic change in economic data, it is a near certainty that the FOMC will approve its first cut to the federal funds rate since the onset of post-COVID-19 inflation in the spring of 2021.
The financial media has justifiably focused on the impending pivot in monetary policy, but there was a second phrase in Powell’s speech that is equally worthy of attention. When Powell explained how the reduction of inflation over the past two years was unaccompanied by a painful weakening of economic growth and labor markets, he acknowledged that this soft-landing scenario was a “welcome and historically unusual result.”2 The unusualness of this scenario cannot be understated. It would constitute a genuinely unprecedented event in U.S. financial history, and those do not occur often. Over the past 234 years, only two events offer reasonable points of comparison to post-COVID-19 inflation – and both ended in recessions before price stability was reestablished. The closest comparable was the post-World War I/Great Influenza inflation of 1919-1920. The second was the Great Inflation of 1965-1982, although the duration of the Great Inflation make it a bit less comparable. Given these precedents, if the Fed manages to reestablish price stability without triggering a recession and/or material weakening of labor markets in the aftermath of COVID-19 inflation, it will constitute a remarkable feat.3
Many investors and economists are already celebrating the achievement of a soft landing even though U.S. financial history strongly suggests that such celebrations are premature. This is because a third series of historical events suggests that the Fed’s battle with inflation is not over. These events occurred in the late 1960s and 1970s when the Federal Reserve tightened monetary policy on several occasions, but then preemptively eased policy when labor markets began to weaken. After they repeated this mistake several times, Americans lost faith in the Fed’s commitment to price stability, which allowed elevated inflation expectations to become entrenched in the U.S. economy. The start-and-stop monetary policy tightening was a major cause of the Great Inflation of 1965-1982. Figure 1 captures several of these effects.
Figure 1: The Great Inflation of 1965-1982
(Monetary Policy Inflation, and Unemployment)4
Perhaps the most important lesson from the Great Inflation is that monetary policy tightening must be sustained until elevated levels of inflation are decisively extinguished. This is why extended periods of high inflation are typically followed by recessions. It is simply too risky to ease monetary policy in anticipation of lower inflation because the very act of easing tends to reignite inflationary pressure.
Soft Landing or Reignition of Inflation
The question in 2024 is whether the Fed’s pivot to accommodative policy will resemble the premature pivots of the 1960s and 1970s, or whether the Fed truly has threaded the needle and orchestrated an unprecedented soft landing. My hope is that the Fed has deftly combined critical lessons from the past with shrewd analysis of the present and will achieve an unprecedented soft landing. But my belief is that the Fed is merely repeating the mistakes that their predecessors made in the late 1960s and early 1970s.
Only the passage of time will reveal which scenario is correct. If the soft-landing scenario is correct, I will be the first to congratulate the Federal Reserve. It will mean that the leadership saw something that was unapparent in the historical record, and they will deserve credit for having acted boldly. That said, the evidence from financial history seems more convincing in this case. It suggests that a pivot to more accommodative monetary policy in September 2024 is premature and, therefore, constitutes a policy error. The fact remains that, despite progress over the past two years, inflation remains well above its 2% target. Meanwhile, labor markets and the economy remain relatively strong. Therefore, the act of loosening monetary policy carries the risk of reigniting inflationary pressure, and the consequences of this would be far graver than the alternative of maintaining tight policy for too long. If inflation reignites, it will impair the Fed’s credibility, which will make it harder to reduce inflation the next time around – just like it did in the 1970s.
Disclaimer: This is a personal newsletter. Any views or opinions expressed herein belong solely to the author and do not represent those of any people or organizations that the writer may or may not be associated with in a professional capacity, unless specifically stated. This is not to be construed as an offer, solicitation, recommendation, or endorsement of any particular security, product, service, or considered to be tax advice. There are no guarantees investment strategies will be successful. Past performance is no guarantee of future results. Investing involves risks, including possible loss of principal.
Jerome H. Powell, Review and Outlook. Federal Reserve Board. https://www.federalreserve.gov/newsevents/speech/powell20240823a.htm
Powell, Review and Outlook. https://www.federalreserve.gov/newsevents/speech/powell20240823a.htm
Mark J. Higgins, Investing in U.S. Financial History: Understanding the Past to Forecast the Future (Austin: Greenleaf Book Group, 2024).
Federal Reserve Bank of St. Louis; Bureau of Labor Statistics.
Good article. Good points. The Fed's actions are curious and hard to understand against the background of history. A president who will lift tariffs and run a stimulative policy is on his way in. Inflation has been over target for 44 months in a row, and inflation expectations (U of M series) have risen sharply, especially the mean of that series. Yet the Fed professes fealty to the 2% target and then does the least it can to hit it. The Fed argues that rates are high enough and restictive even though growth is firm to strong, the unemployment rate has been rising but is still historically low, and the evidence 'out your window' as it were is that restrictive or not there is nothing being restricted and inflation has stopped falling. We are not in the land of Fed believe; but of make-believe.