We are now going through a period of high inflation. Until a few months ago the only thing a lot of people remembered experiencing was low inflation. Now that inflation has spiked up everyone is tearing their hair out and spouting the economics equivalent of "we are all going to die". We are not all going to die.
What has thrown people's expectations off is the extended period of low inflation that, up until recently, we have all been living through. Many think that what we are now experiencing (high inflation) is unprecedented. And, therefore, there is nothing that can be done. It is going to continue on forever. But this is a situation where history can be a very accurate guide. We have been here before.
And there is a second factor. That's the current position the Fed finds itself in. (Queue the segue into historical mode.) I have been following the general state of the U.S. economy for decades. I am familiar with the Fed. I know what it is about. I have investigated how it works (or doesn't) across a period spanning an even longer period. Let's start with the pre-Fed era.
In the 1800s, and especially in the late 1800s, the U.S. went through a series of "panics". That's what they were called, and for good reason. The way banks work is that they take deposits. They then put most of the money back out in the form of loans. The interest and fees the loan portfolio generates allows the bank to make a profit, and perhaps pay a little something back to the depositors for the use of their money.
But every once-in-a-while a rumor would start circulating that a particular bank was in trouble. Sometimes it was true. Sometimes it was not. But once a significant number of people believed that the rumor was true, or even only believed that it only might be true, they moved immediately to pull all of their money out of the bank. This was perfectly sensible. If the bank went under, they stood to lose all or most of any money still held by the bank.
This behavior was called a "bank run". If too many people withdrew their money, then the bank got into trouble. They had enough money around, assuming they were sound, to cover the normal in and out of daily business. But they didn't have enough money to pay off a significant percentage of the funds on deposit. It was out in the form of loans. As a result, few banks survived a run.
And this turned into a self-fulfilling prophecy as more and more people learned how bank runs worked. And that meant more rumors. And that meant more bank runs. And that meant more bank failures. If a number of banks got into trouble people panicked and started pulling money out of all banks. By late in the century panics, periods when there were runs on a lot of banks at the same time, happened once every five to ten years.
This was very destructive to the economy. Banks failed. Business was disrupted. Individuals and companies lost lots of money. Pressure built to do something about it. The result was the establishment of the Federal Reserve, or "Fed" for short, in 1914. It was supposed to regulate banks. That was supposed to reassure depositors and put an end to panics.
It wasn't enough. Until the FDIC, the Federal Deposit Insurance Corporation, was created in response to the start of the Great Depression, panics continued. The FDIC insured banks that the Fed blessed. It had enough money to pay depositors in the event of a run. So sound banks stopped going under and we stopped having financial panics.
But remember, the Fed's job is to be a regulator. Besides making sure that banks are sound they are responsible for the general state of the economy. They are supposed to manage the banking system so that the economy grows steadily, unemployment remains low, and inflation does not get out of control.
For a long time, the Fed was able to do a good job. Banks were sound because the Fed forced them to be conservatively run. Essentially from the end of World War II the Fed was able to keep the economy growing, the unemployment rate relatively low, and inflation under control. I can put numbers to these goals.
The magic number for economic growth was 3.8%. For a long time, if the economy grew at or above a 3.8% rate the incumbent political party retained control at the Federal level. If it fell below 3.8%, we saw a change in which party was in control. The target for unemployment was 3-5%. It was believed that it was impossible to go below 3%. But anything under 5% was considered good.
The target for inflation was 2%. Why not 0%? It turns out that it is hard for businesses to lower prices in a healthy economy. The reasons are complex, and I am not going to get into them. But if the general rate of increase in prices is 2% then some companies will not be able to raise prices that fast. Relative to the rest of the economy, their prices will deflate without the necessity of them actually cutting prices. So, an inflation rate of 2% was considered the Goldilocks spot.
The Fed missed one or more of these targets regularly. But they were generally able to steer the economy back into the sweet spot. But the Fed was a victim of its own success. After a few decades of things working great for everybody, people (the banks and big business) decided that keeping things locked down so tight was not justified. So, a push, led primarily by Republicans, gathered steam to "deregulate".
A Democrat, President Carter, was the first to actually start deregulating things. He didn't deregulate banks. That came later. But the deregulation bandwagon gained so much momentum that it ground on for more than a half century. So, after a period of both incredible economic growth and economic stability, we have gone back to the bad old panic days.
We had the Savings and Loan scandal of the '90s. (Don't ask - everybody has forgotten about it by now.) We had the "Dot Com Bomb" of the early 2000's. We had the Wall Street meltdown just before 2010. And now we have the economic disruption attributed to COVID. The latest sub-phase is the inflation spike that has been all over the news for the last few months.
Truth be told, it was more than deregulation that has been a problem for the Fed. Historically, the main tool the Fed has used was its ability to manipulate interest rates. If the Fed forced raised interest rates, then business would pull back. They would borrow less. That left them with less money with which to grow. Or so the theory went. This pullback would cause the economy to shrink. This caused inflation to decline, but economic growth was hurt, and unemployment went up. This was all to the good if the economy was "overheated".
On the other hand, a lowering of interest rates would cause business to borrow more. That's the theory, anyhow. Businesses would use the increased borrowing to grow and expand. That made economy as a whole grow more quickly. Unemployment would go down, but inflation would go up. This is all to the good if the economy is underperforming, if it is "stalled". And practice matched theory for a long time.
The interest rate tool is often equated to the rudder on a supertanker. A slow turn will result in a large change in direction, if it is allowed to go on for long enough. That is good enough, so supertankers are notorious for having small rudders in comparison to their total size. A small rudder is no problem if it gets the job done.
But what if a supertanker encounters a big storm? The wind can push the supertanker around. After all, it has these giant flat sides. Similarly, a supertanker is big. That means that small waves don't affect it much. But big waves, waves generated by a large storm, do. Supertankers are careful to stay away from storms because of this.
The economy can also be subjected to large and powerful storm-like events. And, if that's what is happening, then the small interest rate "rudder" the Fed uses to put the economy back on course, gets overwhelmed. That's what happened in the Wall Street meltdown. By itself, the interest rate rudder was too small to get the economy back on course.
And then there's the trade-off. The economy is supposed to have either high growth and high inflation or low growth and low inflation. That allows the Fed to play growth off against inflation to move the economy in the right direction to get it back on track.
But the economic theory that predicted that it was impossible to have slow growth and high inflation at the same time proved to be wrong. It happened late in the Nixon/Ford administration. President Carter got growth going, but at the cost of super-high inflation. President Reagan got inflation back under control by forcing a short recession. After that, the standard trade-off was back on.
But the side effect of the Reagan move was to permanently depress economic growth. We have had periods of high employment since. We have had periods of low employment since. But we haven't had a period of sustained high growth since. Experts are now satisfied with a growth rate in the 1-2% range. This is fine for Wall Street. They have figured out how to make money in a low growth environment. But it has been bad for main street and for workers.
So, we have been living in this low growth, low inflation regime for a long time. It looks a lot like stagflation. But, since the stock market has been doing great, the poor state of the underlying economy, and the poor state of household wealth and income (if you exclude the top 1%), gets consistently ignored.
But then things changed drastically a few months ago. The Biden Administration has put a lot of money into the pockets of ordinary Americans. For a while, COVID made it hard for them to spend it. But the response to COVID has evolved and it became easier and easier for people to spend, spend, spend. And they did.
And they spent on goods, not services. Early in the pandemic they spent on services like Netflix. But by the second half of 2021 they were spending heavily on goods like Pelotons. The problem was that the economy was totally unprepared.
The Reagan Administration made it easier for companies to offshore manufacturing jobs, initially to China, but later to all over. The U.S. economy gradually transitioned from being manufacturing based to being service based. We no longer make much in the U.S.A. Instead, we import it.
And COVID screwed that up. Manufacturing was disrupted by the Chinese "zero tolerance" approach to COVID. Shipping was disrupted due to a shortage of longshoremen at the ports and truckers further inland.
The first introduction to this for most of the public was the lack of facemasks. When demand skyrocketed it turned out that the only real mass producer was China. And initially China needed all the masks it could make for domestic use.
Since, then we have been introduced to a variant of the mask story in commodity after commodity after commodity. And it turned out that the U.S. had little or no capability to manufacture masks, or pretty much anything else, domestically.
It is important to understand that the underlying cause of a lot of these problems was a side effect of demand rising sharply. Demand for masks certainly soared almost overnight. Demand for other goods didn't rise as dramatically as the demand for masks did. But demand went up pretty dramatically for many goods at the same time.
In recent years the world economy had gotten used to producing a certain amount of goods. It has also gotten used to the demand for goods growing only slowly. That's a side effect of the slow-growth regime that we have all gotten used to. When an across-the-board spike in demand for goods of all kinds hit, the world system for production and distribution got overwhelmed.
So, we saw bottlenecks everywhere. They happened at the manufacturing level. They happened at the shipping level. They happened at the warehousing and retailing level. Volumes in all these areas shot up and none of them were prepared to handle the increase. Chaos ensued.
The size and breadth of the increase in economic activity is best demonstrated by the fact that in 2021 U.S. GDP shot up by 5.7%. Remember, the old "good" number was 3.8%. It turns out that you have to go back to the Reagan Presidency to find a year in which U.S. GDP grew by a comparable amount. And, with the notable exception of China, GDP went up substantially pretty much everywhere. It was not just a U.S. phenomenon.
The obvious and expected side effect of this is inflation. If there is a shortage of goods, and people will continue buying them even after the price goes up, then prices are bound to go up. But it is important to note that this is happening in a surprising environment. Unemployment is way down. And wages are up. Owners are finding it hard to hire and retain employees even after raising wages by historically large amounts.
The law of supply and demand predicts that, if an employer raises wages, more people will apply for a job. But that hasn't happened. It has particularly not happened in traditionally low wage sectors of the economy like hospitality and retailing. This difficulty in filling jobs is one of several contributors to the widespread "we are all going to die" sentiment.
I am now going to focus on the Fed. It is part of the Fed's remit to worry about this sort of thing. And they do. If we go back a few years, there was this long period of time where the general consensus was that the Fed was not up to the task. It was the whole "rudder on the supertanker" problem. The Fed saw the economy getting deeper and deeper into trouble.
The Fed needed to apply stimulus. So, they did. The kept lowering and lowering and lowering interest rates, trying to get the economy to improve. It didn't, at least not by enough. Eventually the Fed lowered interest rates all the way to zero. If that doesn't work, what's the next move?
Some central banks (the term applies to the Fed equivalents in other countries) managed to find a way to drive interest rates negative. That was supposed to be impossible, but they found a way. But even negative interest rates didn't work.
This all happened during the Wall Street meltdown. By itself, right full rudder was not enough to turn the supertanker. The Fed, staring into the economic abyss and aware of its own history, decided to do more. Specifically, they turned to what became known as "extraordinary measures". One measure went by the name "quantitative easing". Mostly what they did, however, was to buy lots of investment securities. Eventually that worked and the hemorrhaging stopped. And the economy began to slowly recover.
After it became apparent that the economy was on the mend, the Fed stopped all the extraordinary measures except its program of purchasing investment securities. That it continued, but at a reduced rate. Many, but not all experts argue that one reason the recovery was so slow was because the Fed dialed back prematurely. In their defense, they never completely stopped, and opinions on the matter differ. After a few years they also moved interest rates up slightly.
They went back to zero interest rates and increased the amount of investment securities they were purchasing at the insistence of President Trump. Both of these steps were highly stimulative. The changes forced by Trump were, in my opinion, unnecessary. But he wanted the economy to do as well as possible on the theory that it would help with his reelection. He did not care whether or not it was the right policy for the economy.
The point of all this is to make it crystal clear that the Fed is currently stimulating the hell out of the economy. They have effectively had the interest rate rudder jammed all the way over to the right for many years now. That means that, if they shift the rudder to the left by forcing interest rates up, they have a rudder that is effectively twice as big as it ordinarily would be.
But wait. There's more. They are also still buying lots of investment securities every month. That also stimulates the hell out of the economy. In the years immediately after the Wall Street meltdown they had the "stimulate the economy" knob turned way up. They have since dialed it back down some. Then Trump made them dial it back up. It is not dialed as high as it was in the early days. Still, it is still dialed high enough to produce a strong stimulative effect.
If we return to our supertanker analogy, think of the securities purchase program as a second rudder, a really big one. For a while it too was jammed far to the right. Then it was moved more toward the center. Then it was moved right, but not so much that it is now jammed all the way over.
The result of all this is that the Fed is in a great position to get inflation under control. They can do the usual "move the rudder left " thing by increasing interest rates. FYI, a typical range for 10-year government bonds is 3-5%. Today, the rate is 1.8%, and that's up considerably from where it was a couple of months ago.
Historically, a normal range for mortgages would be in the 4-6% range. But it has been a long time since people expected to pay 5% for a mortgage. For contrast, I paid 8.5% in the '80s for my mortgage.
Moving interest rates to the range that used to be considered normal would take some steam out of the economy. The Fed has recently signaled that it intends to do so. That was enough to drive the "big three" (the Dow Jones Industrial Average, the S&P 500, and the NASDAQ) stock indexes down sharply. (They have all recovered somewhat in the past few days.)
But that's not even the modern Fed's big gun. The Fed now has what is described as an "inflated balance sheet". The Fed literally owns a lot of investment securities. And, as part of its extraordinary measures it has been buying more because that's what Trump pressured it to do.
At a minimum it could shut down its program for buying securities. The current plan is for it to "taper", to lower the total amount of securities it purchases each month. Eventually the amount would get to zero. That would move the effect of the extraordinary measures to neutral.
The Fed can go even further, if it decides it needs to. It can raise interest rates to a level that is above historic norms. It could also begin selling off its large portfolio of investment securities. It has complete control over how fast it sells them. It can go with whatever rate is necessary to get the economy back to where it needs to be.
So, the Fed is in a position to exert however much pressure is necessary in order to bring inflation down. But that's not all. COVID is still gumming up the works. But it may be that Omicron will be the last wave. And Omicron is likely to decline nearly as fast as it increased. The economy may soon no longer have COVID holding it back.
Doing almost anything is hard now, due to COVID. The movie and TV production business has responded to the threat COVID represents by saddling itself with a long list of safety protocols. They slow things down and make it harder and more expensive to do a show. We see this play out in the way new content is currently being released in dribs and drabs.
If COVID is in our rear-view mirror, TV and movie production can ramp back up to where it was in the before times. It could even expand. And the same is true, usually to a lesser extent, in industry after industry.
For instance, it will be easier to unsnarl shipping delays by adding capacity when COVID is no longer an issue. And then there is the hospitality business. Cruise ships are a mess. The COVID inspired rules and regulations add to costs and diminish the cruising experience.
In spite of all the new rules and procedures there have been multiple instances of large COVID outbreaks on ships. Adding to their problems is the fact that this has got to be keeping some cruisers away. That's bad for business. It also gets in the way of efforts to increase business.
Cruise ships are run by large companies. Their size gives them access to a lot of resources. Consider the plight of a small business like a restaurant. They don't have the same access. But that doesn't stop them from having the same kinds of problems. People have to be staying away because of COVID concerns.
Unfortunately, so have the people who work at restaurants. Restaurants have been having awful problems getting and retaining staff. This is true even after wages have been raised substantially. No doubt, some people don't want to take the risk. But also consider the hassle.
When it comes to dealing with COVID, restaurants have a number of approaches to choose from. But the only one that is totally hassle free is choosing to close. If they decide to stay open instead, no matter what approach they decide on, some group or another is going to be mad at them.
That anger translates into more unruly patrons, and patrons who, when the get out of line, get much further out of line than they used to. Who wants to work a dead-end job with shitty pay and then have to deal with asshole patrons?
If COVID goes away, then restaurant employees will no longer be worried about their health. They will also no longer be expected to be the COVID police. That is going to result in fewer irate patrons. That should translate into happier employees and more business.
If there are more restaurants chasing the diner's dollar, that should put pressure on restaurants to keep their prices down. And that should translate to less inflation. A similar analysis can be applied to many other industries.
So, there are many reasons to believe that our current bout of inflation will be a transient one. Does that mean that it will be gone in a month or three? No! But we are already seeing signs that inflation is starting to moderate. It will take a while, but we will get there.
The press will still be able to come up with scary inflation stories for a few more months. As long as they can compare the current situation to how things were early last year, the current numbers will look bad by comparison. But that ploy will stop working at some point. And when it does, the stories will disappear, as if by magic.
The Fed is in a better position to deal with the inflation problem than at any other time I am aware of. And, as I said, I have studied many decades of Fed policy and how well it has or hasn't worked. They have the tools, and they know how to use them. We will be fine as long as they are allowed to do so.
And the Fed won't be going it alone. There are other forces in play that will also be pushing in the direction of inflation moderating.
Good news.
