In a speech to the American Bankers Association in May of 1970, Arthur Burns assured the bankers in attendance that his policies as the Chairman of the Federal Reserve would lead to prosperity without inflation. Here is a quote from his speech:
Although the forces making for inflation in modern society are strong and pervasive, these forces need not prevail. Stabilization policies can be formulated and executed in a way that will permit our economies to enjoy the benefits of prosperity without inflation.
At the time of his speech, inflation was about 6% and the rate of unemployment was 3%. By 1974 – just three and a half years after Burns prophesied about prosperity without inflation - inflation had doubled to 12%, the unemployment rate had tripled to 9%, and the U.S. economy was in the midst of one of the worst recessions in modern U.S. history. The S&P 500 had declined 37% in nominal terms in those three and a half years, a 54% decline adjusted for inflation.
So much for prosperity without inflation.
At KP7, we politely ignore the words of the intellectual elite. The intellectual elite, because of their very position in society, have different motivations than most of the rest of us. They have different agendas, different incentives.
In Bamboozled by the Intellectual Elite, we described why we were highly skeptical of Jerome Powell’s and Janet Yellen’s claims in the fall of 2021 that inflation was “transitory”. The passage of time has shown that our skepticism was well placed.
Ben Bernanke told us the problems in the subprime real estate market were “contained” just prior to one of the biggest real estate crashes in modern history created by the very thing Bernanke told us was contained.
Today, the U.S. Federal Reserve tells us they will do whatever it takes to bring inflation down to their 2% target. We are once again skeptical.
Why? Because the level of debt that exists in the U.S. economy today restricts the Fed’s degrees of freedom in dealing with inflation without at the same time creating a catastrophe among borrowers.
One essential element of curbing inflation is to reduce the supply of money. Reducing the supply of money entails high interest rates and restrictive credit. High interest rates and restrictive credit are tough on borrowers because they increase borrows’ debt service requirements and make refinancing their debt more difficult. Bringing inflation under control, in short, creates pain among borrowers. The more debt that exists in the system, the more pain created from the actions required to bring inflation under control.
When Paul Volcker successfully brought inflation down in the early 1980s, he took short-term interest rates to nearly 20%. Borrowers got crushed. A third of all savings and loans institutions that existed when Volcker started his fight against inflation would eventually fail outright. Yes it was painful, but prosperity with low inflation eventually followed as Volcker succeeded in controlling inflation.
Both Burns and Volcker had the ability to create prosperity without inflation. Volcker executed. Burns, despite his rhetoric, did not.
Jerome Powell, in our view, does not have the ability to tame inflation without at the same time creating enormous stress – and in all likelihood crisis - in the U.S. credit markets.
When Burns gave his speech in the spring of 1970, U.S. federal debt as a percent of GDP was below 40%. When Volcker tamed inflation in the 1980s, U.S. federal debt as a percent of GDP was just 35%. Today, U.S. federal debt is 130% of GDP and heading higher.
That level of debt restricts Powell’s degrees of freedom in dealing with inflation. Volcker essentially wiped out the U.S. Savings & Loan Industry in order to curb inflation. The amount of financial pain needed to curb inflation today would be an order of magnitude higher.
Unlike Burns and Volcker, Powell is faced with the combined threats of inflation and a highly-levered economy. Fixing inflation will create catastrophic stress and likely crisis in the credit markets. Easing the debt burden in all likelihood means more inflation.
Burns and Volcker had choices. Powell doesn’t.
In baseball, a baserunner is caught in a pickle when he is stranded between two bases. The opponent is standing on one base with the ball. If the baserunner runs to that base, the opponent tags him out. If he runs to the other base, the opponent throws the ball to his teammate standing on the other base and the teammate tags him out. Either way the baserunner is out. There are no good choices with pickles.
The Fed is in a pickle. All baserunners know that the only painless escape from a pickle is to avoid the situation in the first place. The Fed didn’t.
Because of the historic levels of debt in the U.S. economy today, we think the financial stress needed to bring inflation down will eventually force the Fed to abandon its 2% inflation target. Perhaps it already has.
