The Siren Song of a Soft Landing is Getting Louder
History Demonstrates That Tight Monetary Policy Cannot End Prematurely
Happy Halloween! I did not originally intend to make this newsletter thematically consistent with the holiday, but it naturally gravitated in that direction. The theme today is to be wary of dangers in disguise. Most of the newsletter focuses on post-COVID-19 inflation and the Federal Reserve’s monetary policy, but there is a second “Siren song” that is worthy of mention. To this end, I encourage all subscribers who are trustees of institutional investment plans to consider attending a free webinar that I will be hosting on November 15, 2023 at 11:00 am PDT. The webinar is titled, “Fulfilling Your Fiduciary Duty: Weighing the Costs of Institutional Investment Strategies.” The discussion focuses on the importance of evaluating the substantial and growing fees that are embedded in most institutional investment plan portfolios. As the webinar will reveal, there are many “Sirens” who encourage such behavior, and it is important for trustees to recognize the likely fate that awaits them if they heed their advice. For those interested in registering, please click here.
Now, on to the topic of inflation and the Federal Reserve’s ongoing efforts to contain it.
The Song of the Sirens
“First you will come to the Sirens who enchant all who come near them. If any one unwarily draws in too close and hears the singing of the Sirens, his wife and children will never welcome him home again, for they sit in a green field and warble him to death with the sweetness of their song.”
Homer, The Odyssey
In the epic poem, The Odyssey, Homer tells the tale of Odysseus’s perilous journey home from the Trojan War. During his voyage, he barely survives encounters with several supernatural threats. One challenge was to sail safely past an island inhabited by the Sirens, which were bird-like creatures that lured sailors to their death by charming them with their beautiful songs. The goddess Circe advised Odysseus to protect his crew from the Sirens by plugging their ears. She told Odysseus that he could listen to the singing, but only if he lashed himself to the mast and ordered his crew to resist his efforts to break free.
As Odysseus’s ship approached the island, the crew sealed their ears with beeswax and tied Odysseus to the mast. When two Sirens appeared, Odysseus was immediately spellbound by the beauty of their voices. He struggled to free himself from the mast and follow the Sirens to what appeared to be an island paradise. Heeding Circe’s advice, the crew members tightened their captain’s bindings. After the voices of the Sirens faded, Odysseus thanked his crew for saving him from the torture and death that surely awaited him on the island.
Post-COVID Inflation and the Return of the Hawks
In early 2022, the Fed was caught off guard by the persistence of post-COVID-19 inflation. They had erroneously assessed that the spasm of inflation would prove “transitory.” There are many explanations for their miscalculation, but the most compelling seems to be that there was simply nobody alive in the entire country who had experienced something similar. This was unfortunate because the similarities between post-COVID-19 inflation and the post-World War I/Great Influenza inflation in 1919-1920 were striking. The similarities were clearly outlined in a May 2021 paper published here.
Although recognizing the similarities of the post-World War I/Great Influenza inflation would have proven helpful in 2021, it is no longer a relevant point of reference. Elevated levels of inflation have persisted for more than two years, which now makes the failed monetary policies of the late 1960s and 1970s the most important comparable.
Fortunately, most FOMC members are aware of the mistakes that led to the Great Inflation, and current monetary tightening policies appear bent on avoiding a recurrence. Nevertheless, as the tightening becomes more painful for Americans, the Fed is getting more pressure to tilt toward more dovish policies. Yielding to such pressure would constitute a grave error. In the late 1960s and early 1970s, the Fed abandoned monetary policy tightening prematurely in response to the same pressures. Consequently, the American public concluded (correctly, as it turned out) that the Fed lacked the fortitude to maintain price stability. This, in turn, allowed elevated levels of inflation expectations to become entrenched in the economy, leading to more than a decade of persistently high inflation. The Great Inflation of 1965-1982 only ended when Paul Volcker enacted draconian monetary policies, thereby reinstating the Fed’s credibility. Briefly revisiting how Volcker accomplished this objective reveals several lessons that are important to understand today.
Paul Volcker Ends the Great Inflation
“[Our] approach enforced upon the Federal Reserve an internal discipline that had been lacking: we could not back away from our newfound emphasis on restraining growth in the money supply without risk of a damaging loss of credibility that, once lost, would be hard to restore. To overdramatize a bit, we were doomed to follow through. We were “lashed to the mast” in pursuit of price stability.”1
Paul A. Volcker, former chairman of the Federal Reserve Board
The costs of inflation were unbearable in the late 1970s. In August 1979, President Jimmy Carter appointed Paul Volcker as the new Chairman of the Federal Reserve Board with the hope that he could contain it. On October 6, 1979, Volcker began a famous monetary tightening campaign that finally ended the Great Inflation. There were several import components of Volcker’s plan, which he outlines in Changing Fortunes. One of the more important ones was the temporary abandonment of his standard policy of encouraging dissent among FOMC members. Volcker concluded that a unified front was necessary after witnessing the market’s wild reaction to a 4-3 decision by the FOMC to raise the discount rate by 50 basis points in September 1979. Volcker later commented that, “the split vote [of the FOMC] spelled hesitation and left the impression that this would be the board’s last move to tighten money. The whole maneuver was therefore counterproductive in seeming to send a message that inflation could not be, or would not be, dealt with very strongly.”2
Over the next two years, the Federal Reserve was both steadfast and united in its commitment to extinguish inflation decisively despite the painful (but temporary) costs of higher unemployment and a severe recession. As a result, the nation endured an extended period of excruciatingly high interest rates—with the federal funds rate peaking at approximately 20%. During this time, Americans suffered a sharp rise in unemployment, which peaked at 10.8% and a brutal recession that lasted from July 1981 to November 1982. But the plan worked, and when the recession ended, price stability had returned. The U.S. then enjoyed a nearly 40-year period of stable prices and relatively low unemployment. The spring of 2021 marked the end of this exceptional streak.3
The Sirens Call Captivates a Fed President
“But we also can’t lose sight of the fact that the Fed has the chance to achieve something quite rare in the history of central banks—to defeat inflation without tanking the economy.”4
Austan Goolsbee, President of the Federal Reserve Bank of Chicago
History reveals that it is very difficult to reverse extreme periods of price instability without causing collateral economic damage. The recessions in 1921–1922 and 1981–1982 provide clear evidence of this fact. For more detail on why it is so difficult, I encourage you to read The Inflation Game: War, Peace, and the Perils of Central Banking. Despite the historical record, central bankers sometimes yield to the temptation to defy the odds and end monetary tightening prematurely. But yielding to this temptation is much like becoming bewitched by the song of the Sirens. What seems like an idyllic path to a paradise of price stability, low unemployment, and strong growth is really a dangerous trap that ends with entrenchment of higher inflation expectations and loss of Fed credibility. This is precisely what happened to the Fed in the late 1960s and 1970s. Former Federal Reserve Chairman Arthur Burns testified to this fact (while also revealing several other costly errors) in his famous “Anguish of Central Banking” speech on September 30, 1979.
Thus far, most FOMC members appear to have resisted this temptation, enabling them to maintain a reasonably united front in their commitment to price stability. On October 19, 2023, Chairman Powell reinforced their unanimity when he stated, “my colleagues and I are united in our commitment to bringing inflation down sustainably to two percent.”5
But there is at least one FOMC member that appears to be listening to the irresistible Siren song of a soft landing. On September 28, 2023, Austan Goolsbee, president of the Federal Reserve of Chicago, delivered a speech to the Peterson Institute for International Economics. In his speech, he seemed to encourage a more dovish monetary policy in the hope that the Fed can defy the odds and navigate a soft landing. He concluded the speech by saying “If we succeed, the golden path will be studied for years. If we fail, it will also be studied for years. But let’s aim to succeed.”6
Goolsbee’s statement has the same feel of somebody listening to the dangerous song of the Sirens. The problem, however, is that history demonstrates that taming inflation without economic pain is highly unlikely. What makes Goolsbee’s statement particularly alarming is that he only supported his thesis with data that extends back to 1960. Yet the most comparable event in U.S. financial history was the inflation of 1919-1920, and that ended with a severe (but relatively short) recession and brief period of deflation.
The Fed Must Remain Steadfast
“The simplest is this: Inflation if it reemerges, ought to be nipped in the bud; the longer we wait, the harder it gets to reign in.”7
Robert J. Samuelson, Author of the Great Inflation
In 2010, Robert J. Samuelson published an insightful book that analyzed the causes and effects of the Great Inflation of 1965-1982. Near the end of the book, he offered the above quote as the most important lesson. If Post-COVID-19 inflation ends like the ones that were most similar in the past, it is highly likely that Americans will feel significant economic pain. The good news is that it will not last nearly as long as the pain of persistent and entrenched inflation. I hope that the FOMC remains steadfast and unified over the coming year, because history reveals that the short term pain is worth the long term benefit of price stability.
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 not guarantees investment strategies will be successful. Past performance is no guarantee of future results. Investing involves risks, including possible loss of principal.
Notes
Paul Volcker and Tyoo Gyohten, Changing Fortunes: The World’s Money and the Threat to American Leadership, (New York: Times Books, 1992).
Paul Volcker and Tyoo Gyohten, Changing Fortunes: The World’s Money and the Threat to American Leadership, (New York: Times Books, 1992).
Mark Higgins, Investing in U.S. Financial History: Understanding the Past to Forecast the Future, (Austin: Greenleaf Book Group, forthcoming February 2024).
Robert J. Samuelson, The Great Inflation and Its Aftermath: The Past and Future of American Affluence (New York: Random House, 2010).