When Money Becomes Political
As we’re reminded daily, we haven’t seen inflation this bad in over 40 years. It was in 1980 when the Consumer Price Index (CPI) reached a stunning 13.5%. Like today, the nation turned to the Federal Reserve to “cure” our price problem. And like today, the Fed used their principal monetary tool, interest rates, to cool the rising prices. Then Chairman Paul Volcker and the rest of the Federal Open Market Committee members eventually raised the fundamental Federal Funds Interest rate by 400% (from 4.6% to 19%).
Let’s be clear: this strategy of raising interest rates works because it depresses overall commercial activity. As rates rise, industries cut back on investment, consumers curtail the amount they purchase, and eventually, prices stabilize, but in a much weaker overall economy. That’s why when these rate hike strategies begin, they’re almost always followed by a Recession (a more fragile economy).
1980 proved to be a watershed year. Inflation peaked, interest rates peaked, and a new President was elected — a President who brought an all-new way of looking at the economy. From the 1930s until 1980, most government officials believed that the economy must be “managed” by Washington. They were following the thinking of English Economist John Maynard Keynes. Keynes’s writings (principally his book The General Theory of Employment, Interest, And Money) revolutionized politicians’ economic role.
The General Theory was written amid the Great Depression and should be seen in that light. The country was languishing and needed some boost to bring it out of the doldrums. Keynes suggested that the Government should provide that “boost.” Eventually, Washington would use Keynes’s concept of deficit spending to create large social programs: Work Progress Administration, Civilian Conservation Corp, and even Social Security all came from Keynes.
Deficit spending is the golden elixir for politicians of a particular bent. At last, Washington could spend like never before, and the thinking was that it would help the economy. Deficit spending, for most Presidents, became their modus operandi. Spend, spend, spend, more new social programs. They will all help the economy. I’m sure that Keynes would roll over in his grave if he knew the extent to which his thinking, designed only to help the dire times of a Depression, was being used to drive massive government debt, something that Keynes rejected.
So for half a century, this country lived under this bastardized version of Keynes, where Washington used every excuse they could to expand the role of Government in the economy.
But as we say, that all changed in 1980. That year, a new President, Ronald Reagan, was elected. But more importantly, he brought an all-new way of looking at the economy. Reagan was an advocate of the monetary policies of Milton Friedman. Friedman was a Nobel Laureate in Monetary Economics and, at the time, worked at the Hover Institute, a think tank located at Stanford University.
Although their careers overlapped briefly, Friedman wrote against an entirely different economic background than Keynes. Keynes attempted to bring the Western World out of one of the most profound economic declines ever. In contrast, Friedman was addressing issues that arose during a time of relative prosperity, issues like inflation (NOT Keynes’ problem of deflation).
It was Friedman who encapsulated the single best description of inflation:
“Inflation is always and everywhere a monetary phenomenon, in the sense that it is and can be produced only by a more rapid increase in the quantity of money than in output.”
In that one statement, Friedman identifies the chief instigators of inflation: the nation’s monetary authorities, those who can increase the money supply. In plain language, this laid inflation’s problems directly at the feet of the Federal Reserve, the US Treasury, the Congress, and most pertinently, the President.
Under Friedman’s approach, the monetary role of the Federal Reserve is to slowly and consistently increase the money supply. So, following the logic, the increase in money supply should never exceed the economy’s growth rate.
Even better than their word, the Reagan Administration held Government spending flat for the remainder of his term while the economy grew between 5 1/2% to 11% per year. Economic growth was greater than money growth. What a concept! We developed an all-new word for what finally occurred in the country: “disinflation.” There was a mild increase in the dollar’s value, so workers’ salaries and wages had progressively greater buying power.
When the 1980s ended, Reagan was no longer in office, and Milton Friedman retired to San Francisco, the nation’s economy was set. Economic growth was outstanding. While we no longer had to worry about inflation, remember it was disinflation.
Unfortunately, Washington immediately went back to its free-spending ways. Even Reagan’s former Vice President, George HW Bush, began pushing for more and more spending, which has accelerated under the last two presidents: Donald Trump and Joe Biden.
What Government Intervention Has Brought US
Today, our economy is firmly in the grip of the Government Interventionists (the neo-Keyseians).
As Friedman predicted, inflation began in 2019 when President Trump injected $3 trillion into the economy through the “Stimulus Programs.” The Government sent funds directly to corporations, state and local governments, certain businesses, schools and hospitals, and families and individuals. Under President Biden, the Government added a final Stimulus Payment of $2 Trillion on March 31, 2022.
Altogether, the monetary base was increased by $5 trillion, the primary contributor to inflation. But don’t be surprised when we won’t hear either of the two Presidents, the Federal Reserve, Treasury Department, or Congress, brag that they created the worst inflation in 40 years or one of this nation’s most significant financial crises directly ahead.
So, as briefly as possible, those are the significant contributors to today’s inflation. There were other simultaneous contributors, especially the price of food and energy, which significantly increased. But neither commodity contributed as much to inflation as the Monetary Base increase.
The War on Inflation
From my perspective, the War on Inflation began on May 31, 2022, when President Biden “invited” Jerome Powell, Chairman of the Federal Reserve, to his office. The people on Wall Street raised their eyes. It was an action that was very much out of character for the President, and the fact that he had made it such a visible meeting was all the more intriguing. I believe that Biden was reading Powell the Riot Act. He likely said: we have to do something about inflation!
Inflation was beginning to take off; for months, the Fed said this was only “temporary.” Powell was a reluctant inflation warrior. Speaking before the Kansas City Fed the year before, Powell articulated the Fed’s basic approach.
“The period from 1950 through the early 1980s provides two important lessons for managing the risks and uncertainties we face today. The early days of stabilization policy in the 1950s taught monetary policymakers not to attempt to offset what are likely to be temporary fluctuations in inflation.15 Indeed, responding may do more harm than good, particularly in an era where policy rates are much closer to the effective lower bound even in good times.” Jerome Powell, at Jackson Hole, Wyoming, August 27, 2021.
Powell was listening to his inner Milton Friedman. He recognized that generally, significant monetary boosts, like the “Stimulus Payments,” usually play out their inflation effect in a year or year and a half. In other words, the most prudent course would be to see if inflation would return to normal.
Of course, Joe Biden would not appreciate such sanguine advice. His poll numbers were beginning to drop, and he was taking a lot of criticism in the press. Although it’s speculation on my part, Biden likely told Powell to start to tighten up. And that’s just what Powell did. Powell and the FOMC raised rates by 450 basis points from that end-of-May meeting. But here’s the point everyone misses: the Fed has increased interest rates by 2100% from a low of 1/4% to the current 5 1/4%. Theoretically, that’s how much the interest rate will rise for short-term loans.
These higher interest rates have created a bond market apoplexy. You may not be aware that the bond markets, by which I mean the US Treasuries, are enduring one of the harshest declines in history. You see, bonds are also interest-rate vehicles. And although the longer maturity bonds are far outside the Fed’s influence (the Fed only sets short-term interest rates), bonds are starting to lose confidence in Washington’s ability to manage the economy.
The past year’s history would indicate that US Monetary Policy is established when the President calls the Chairman of the Fed in his office. What else explains the 180-degree turn by the fed from “ignore the transitory” to the most assertive monetary tightening we’ve ever seen?
When monetary policy becomes political, it’s time to step away from the abyss.
