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September 19, 2022 | Last week in the Financial Times, Frederick Mishkin made an important comment about our departed friend and fellow member of The Lotos Club, Paul Volcker. The former Fed Chairman and President of the Federal Reserve Bank of New York was both a good economist and an astute politician. Truth is, every Fed chief since Governor Charles Hamlin needed to consider political trends and events, but especially since the end of WWII. Mishkin wrote:
“Paul Volcker is considered to be a GOAT (greatest of all time) central banker because he and the US Federal Reserve broke the back of inflation in the early 1980s. However, less talked about is the serious policy mistake that the Volcker Fed made in 1980. The result was a more prolonged period of high inflation that required even tighter monetary policy, which then resulted in the most severe US recession since the second world war up to that time.”
The fateful mistake Mishkin describes was the decision by the FOMC to reduce interest rates in May of 1980 even though inflation was still rising, a situation not unlike today. Those who now call for the Fed to slow rate hikes, at least before last week's inflation data, would do well to recall this period. “This action was taken despite the fact that inflation reached a peak of 14.7 per cent in April,” Mishkin recalls nearly half a century later. Fact is, Paul Volcker blinked and Ronald Reagan won the White House in 1980.
By dropping interest rates, the FOMC seemingly helped President Jimmy Carter, a fellow Democrat, but in fact the election of Ronald Reagan was already done by mid-year. Inflation, related interest rate hikes over the previous year and the Iran hostage crisis sealed Carter’s fate, a historical parallel that many Americans ought to ponder as the mid-term election approaches and memories of COVID fade.
Volcker knew that Reagan was the likely winner, in large part because of the political advice he received from Richard Whalen, who had been a confidant and speech writer for Reagan going back to 1976 and for candidate Richard Nixon before that. Whalen eventually became a special advisor to Secretary of State William Rogers and sous-chef in the early Reagan kitchen cabinet. He also remained a loyal friend and political confidant to Volcker and his successor, Alan Greenspan. In 1983, Whalen and NV Senator Paul Laxalt engineered the reappointment of Volcker to a second term as Fed Chairman.
Richard Whalen & Ronald Reagan (1982)
Once President Reagan won the election, Volcker turned back to fighting inflation at the end of 1980, sending the US into the worst recession in the post-WWII era. We remember Volcker for his later actions, not for blinking in May 1980. Even as we lionize Volcker, history has been unkind to former Fed Chairman Arthur Burns for doing too little on inflation during the term of President Richard Nixon. Nixon and his thugs bullied Chairman Burns in a despicable fashion. The fact was, the worry about the economy and unemployment, and possible social unrest following the 1968 riots, took precedence over inflation in the early 1970s.
“In early August, at the insistence of Treasury Undersecretary Paul Volcker, Nixon held a secret meeting at the Camp David retreat to discuss the crisis affecting the economy. Congress had given Nixon broad powers over wages and prices in 1970 via the Economic Stabilization Act, and Nixon was determined to use them. Treasury Secretary John Connally, who Nixon recruited for the Cabinet in 1970, laid out the plan to the assembled staff, including the wage and price controls, an import surcharge, and closing the gold window. Nixon admitted at the time that he was not sure of the impact of the decision to close the gold window. Fed Chairman Burns was against closing the gold window, but was in agreement with the other aspects of the Nixon NEP. Connally would say after the summit meeting that when Nixon announced the unilateral United States departure from Bretton Woods: ‘We have awakened forces that nobody is at all familiar with.’”
Those forces referred to by Secretary Connolly are the precursors of inflation. The secular explosion of inflation over the past half century, despite the heavily doctored statistics to the contrary, is illustrated very well by the rate of growth of the assets of the US banking system and, more recently, the erratic management of the Fed’s balance sheet under Janet Yellen and Jerome Powell. The sharp increase in the Fed’s securities portfolio in response to COVID represents an institutional failure by the Fed, which caved into political pressures in the same way as Paul Volcker did 40 years earlier.
History makes too much of our friend Chairman Volcker when it comes to monetary policy and not enough about his careful treatment of the big banks. He was, after all, a Democrat from New Jersey, a state know for its special love of large banks. Volcker and his colleagues at the Federal Reserve Board permitted the largest banks to hide exposures “off-balance sheet” and thus laid the groundwork for the 2008 financial collapse.
Citigroup, Wachovia, Lehman Brothers, Countrywide and Bear Stearns failed in the collapse of the private mortgage market that began in 2006. When we asked Chairman Volcker why he and FDIC Chairman William Issacs (1981-1985) allowed the big banks to inflate their leverage after the Latin debt crisis, Volcker said over lunch in 2017: “They were broke. What else was I going to do?”
Lunch at 30 Rock (2017)
Hidden off balance sheet leverage led to the failure of half of the large banks and nonbanks in the US in 2008, a deflationary catastrophe. Fortunately, the FOMC recalled Irving Fisher, did the math and realized that they needed to substitute demand from the central bank for several trillion dollars in suddenly absent private demand to avoid a 1930s style debt deflation. Chairman Ben Bernanke et al picked benevolence instead of Bagehot-style deflation and won the day.
In “Deflation, Not Inflation, is the Threat,” we discussed why quantitative easing or QE was the right choice in 2009. But then the FOMC under Janet Yellen and Jerome Powell made the same mistake as Volcker in 1980 and played politics with QE. The result is a far worse inflation problem than would have existed without an extra year of QE and several trillion in unnecessary fiscal stimulus. Just as Volcker made inflation worse in 1980 by hesitating to attack immediately, Yellen and Powell erred by pretending to know how and when to fine tune.
Yellen and then Powell did too much for too long, and bought way too many bonds. Those Ginnie Mae 1.5% and 2% MBS will still be sitting in the Fed's portfolio long after Powell and Yellen retire from public life. Even today, Powell and the FOMC admit that they cannot quantify the value of QE vs a given decline in federal funds, thus what was the basis for this public action?
Externalities like Ukraine were the accelerant for global prices, but QE provided the fuel for the inflation fire seen today in US stock valuations and home prices. We described the political pressure on Chairman Burns in "Inflated":
“In 1972, Fed Chairman Arthur Burns kept monetary policy sufficiently expansive to help Richard Nixon win reelection by a landslide, taking 60 percent of the popular vote. The quid pro quo to Burn’ s easy money posture had been Nixon's imposition of price controls the year before, which made inflation at least appear to be low compared to the official statistics. But the economy was weak, no matter what the figures suggested and Americans knew it.”
In the period leading up to the appointment of Paul Volcker as Fed Chairman in 1979, Congress passed the Humphrey Hawkins law, an attempt to legislate an economic reality, namely full employment, that could not really be achieved in practice. The legislation started in 1974 as a proposal to make the U.S. government the employer of last resort, but was altered and amended to compromise with Republicans and also President Carter, who was uncomfortable with this explicitly collectivist jobs-for-all mandate.
Over the four plus decades that have passed since Volcker’s appointment to the Fed, the central bank has done what Congress would not do in 1978, namely socialized economic growth. Freed from the restraint of a gold backed dollar after Nixon closed the gold window in 1971, America’s love for inflation and debt bloomed and, of necessity, the role of the Fed in the US economy has also grown.
The Fed has nationalized the short-term money markets in the US and is about to extend this web of state economic control to the payments system via FedNow. Down the road, the Fed will eventually be able to see into every financial institution and even individual bank accounts via the control over the payments system. None of the expenditure of public funds for FedNow has been authorized by Congress. More, FedNow looks a lot like the deterministic system of control used by the dictator Xi Jinping in communist China.
In 1980, the assets of the Federal Reserve System were a rounding error compared to the $9 trillion in Treasury debt and mortgage backed securities that sit on the books of the central bank today. The Fed is starting to let this portfolio slowly run off, but the FOMC only plans to allow the system open market account (SOMA) to run off down to about $6 trillion. This suggests that much of the asset and home price inflation encouraged by Chairs Yellen and Powell is probably permanent.
The kids may never own a home thanks to Janet Yellen. The 2% inflation target explicitly adopted as policy by the FOMC speaks to the abandonment of the legal mandate from Congress for "price stability." As George Orwell said in Nineteen Eighty-Four, 2+2=5. The fact that price increases during 2020-22 are unlikely to be reversed marks a major difference with the experience with inflation under Paul Volcker, as we highlighted in "Inflated":
“In a 1982 memo from Paul Krugman and Larry Summers, who were both then working in the Reagan White House, to William Poole and Martin Feldstein, the two economists predicted that inflation would again begin to accelerate because the reduction in inflation engineered by the Fed was only temporary. But Summers, Krugman, and many other liberal economists were wrong. In fact the relentless rate squeeze by the Fed and a lot of positively coincidental and mostly external trends broke the inflation in the United States, but did not really instill fiscal sobriety. But Paul Volcker broke the momentum of inflation and also took sufficient demand out of the economy to give the crucial impression of price stability.”
The natural human tendency to accede to immediate demands for jobs and growth has led the US down a path where future inflation is a given, especially with Congress unwilling to balance the federal budget. When we praise or chide Chairman Volcker or Yellen or Powell, we should remember that they are first and foremost political figures. Volcker rebuked Bernanke and Yellen in an essay for Bloomberg ("What's Wrong with a Two Percent Inflation Target") before his death in 2019:
“Deflation is a threat posed by a critical breakdown of the financial system. Slow growth and recurrent recessions without systemic financial disturbances, even the big recessions of 1975 and 1982, have not posed such a risk. The real danger comes from encouraging or inadvertently tolerating rising inflation and its close cousin of extreme speculation and risk taking, in effect standing by while bubbles and excesses threaten financial markets. Ironically, the ‘easy money,’ striving for a ‘little inflation’ as a means of forestalling deflation, could, in the end, be what brings it about. That is the basic lesson for monetary policy. It demands emphasis on price stability and prudent oversight of the financial system. Both of those requirements inexorably lead to the responsibilities of a central bank.”
The Fed has largely failed in the legally mandated focus on "price stability" because Americans love inflation and debt. Instead, the Fed is slowly taking over the internal financial machinery of the US economy. The nationalization of the money markets, the demise of LIBOR and soon FedNow, concentrate vast new power in the hands of Jerome Powell and the FOMC. The political imperative for short-term gratification is overwhelming in a democracy, especially when the levers of policy are in the hands of progressives like Janet Yellen, who really don’t mind some inflation.
As the cost to the Treasury of interest rises, pressure from Congress on Powell to back off on fighting inflation will grow even as we pay homage to the memory of Paul Volcker. Everyone in the investment world wants to believe there is intelligent design in monetary policy and across the street at the Treasury, but evidence suggests instead a lack of focus. We desperately want to believe that Powell and his colleagues on the FOMC can manage a process with rising market interest rates and federal debt, while deliberately shrinking private market liquidity under quantitative tightening or QT.
The curse of Humphrey-Hawkins is that ever more radical policy moves by the Fed to achieve the impossible dream of full employment are slowly destroying the private marketplace. As the scale of Fed open market operations has grown since 2008, market volatility has increased, rendering the adjustment process from QE to QT ever more problematic for private market participants.
The on-the-run forward mortgage contract in TBAs, of note, swung 150bp in the past two weeks. The Fed has now ended purchases of agency collateral and has begun QT in earnest. Year-end 2022 promises to be more of the same volatility and lack of liquidity we’ve seen before. We hope and pray the Fed will do a better job managing bank reserves than they did in September 2019, but perhaps this expectation is unreasonable?
