The cost of living is high, and the Federal Reserve chairman says tackling it is his top priority. Financial markets don’t quite know how to react.
That, in a nutshell, is the situation now that Jerome H. Powell, the Fed chairman, is raising interest rates to reduce inflation, which has not been this high in 40 years.
Something similar happened the last time inflation got out of control. At the time, Paul A. Volcker was the chairman of the Fed. He ripped inflation out of the economy, but at a high cost — plunging the nation into not just one recession, but two in quick succession. Unemployment soared, stocks fell multiple times, interest rates fluctuated, and for a while bonds looked volatile too.
While comparisons between periods can be exaggerated, there are parallels. And because of the enormous role that Mr. Volcker has come to play as a model of a modern central banker, it’s worth looking to his era for reference. The Federal Reserve turned to the historic record for lessons. Investors can also benefit from them.
Simply put, I would say the lessons are twofold.
First, because there were multiple severe downturns, the Volcker era was disastrous for anyone who traded actively and bet wrongly on the direction of the markets. Short-term trading in stocks, bonds and commodities is a dangerous game. It is especially dangerous when market currents are opaque and insidiously strong, as they were then and perhaps now.
But, secondly, the Volcker era was wonderful for those with the patience and resources to live through it. Although Mr. Volcker’s tough treatment of the economy was intentionally disruptive, it led to great bull markets, both in stocks and bonds.
Then and now
Investing would be easy if we knew what the current era would look like 40 years from now. But of course we don’t.
Consider that the S&P 500 fell more than 20 percent from Jan. 3 through mid-June this year — putting stocks in a bear market — only to recover more than 12 percent. The stock is still significantly down and the bear market designation will remain intact until the market returns to its high.
But when will that happen?
This is a key question if you are making short-term bets. This is much less important if you are a long-term buy-and-hold investor, with a horizon of at least a decade and preferably longer, using low-cost index funds that track the entire market.
That’s the approach I’m taking now, and I think it makes sense for most people – assuming, of course, that you can set aside enough money to pay your bills, so the temporary paper losses you experience in the market won’t i hurt you As long as the market eventually goes up, you will prosper.
8 signs that the economy is losing steam
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An alarming prospect. Amid persistently high inflation, rising consumer prices and falling spending, the US economy is showing clear signs of slowing, fueling fears of a potential recession. Here are eight other measures that signal trouble ahead:
Consumer trust. In June, the University of Michigan Consumer Sentiment Survey hit its lowest level in its 70-year history, with nearly half of respondents saying inflation is eroding their standard of living.
The housing market. Demand for real estate has fallen, and new home construction is slowing. Those trends may continue as interest rates rise and real estate companies, including Compass and Redfin, lay off employees in anticipation of a downturn in the housing market.
Med. A commodity seen by analysts as a gauge of sentiment about the global economy – due to its widespread use in buildings, cars and other products – copper has fallen more than 20 percent since January, hitting a 17-month low on July 1.
Butter. Crude oil prices have risen this year, partly due to supply constraints resulting from Russia’s invasion of Ukraine, but have recently begun to fluctuate as investors worry about growth.
The bond market. Long-term interest rates on government bonds fell below short-term rates, an unusual phenomenon that traders call a yield curve inversion. This suggests that bond investors are expecting an economic slowdown.
The Volcker era clearly illustrates the problem. In the long run, investors have done well. For short periods, their experience was maddening.
Emergency shifts
Mr. Volcker became chairman of the Fed on August 6, 1979 as an appointee of President Jimmy Carter and served until August 11, 1987 under President Ronald Reagan.
That period and the present are by no means identical. Only in monetary policy do the causes of the great inflation then and the great inflation now arise from different, though superficially similar, roots.
In both periods there were oil price shocks: one in 1973 and 1974 and another in 1978 and 1979; as well as the 2022 oil price shock.
But the impetus for the big inflation of the 1970s and 1980s goes back at least to the mid-1960s, to President Lyndon B. Johnson’s spending on the Vietnam War and the Great Society, which the Federal Reserve accommodated with loose funds. monetary policies.
In addition, Congress took the U.S. off the gold standard in 1968. And on August 15, 1971, President Richard M. Nixon suspended the convertibility of the dollar into gold for foreign governments, which until then could obtain it from the U.S. government at $35 an ounce .
It is little remembered that Mr. Volcker himself, as Under Secretary of the Treasury for Monetary Affairs, recommended that Nixon take this step, and that Mr. Volcker presided over the beginning of the floating exchange rates that we now take for granted. . The dollar weakened sharply in response to the Nixon-Volcker policies, adding to the inflation that Mr. Volcker would later fight at the Fed.
When Mr. Volcker became Fed chairman in 1979, inflation was over 11 percent a year and the unemployment rate was nearly 6 percent. The bull market in stocks began in 1974 and continued for months, even though Volcker’s Fed had begun to tighten monetary policy with a remarkable change in approach—one that makes current efforts look like nothing.
On Saturday, October 6, 1979, Mr. Volcker “announced a radical change in the conduct of monetary policy,” Jeremy J. Siegel, an economist at the University of Pennsylvania, writes in the book Stocks for the Long Run.
“No longer will the Federal Reserve set interest rates to guide policy,” Professor Siegel said. “Instead, it will exercise control over the money supply regardless of interest rate movements.” The market knew that meant sharply higher interest rates.”
By reducing the money supply and leaving short-term interest rates floating, the Federal Reserve was effectively allowing interest rates to stop rising.
The immediate reaction in the stock market was severe.
“Stocks tumbled, falling nearly 8 percent on record volume in the 2½ days following the announcement,” Professor Siegel wrote. “Shareholders shuddered at the prospect of sharply higher interest rates that would be needed to tame inflation.”
By March 1980, the Fed funds rate was an astounding 17 percent, compared to just 2.5 percent today. It would top 19 percent the following year — and the money supply, which was the Fed’s main target, was shrinking sharply.
Still, despite periodic short-term dips, many stock market traders remained bullish. They were either oblivious to the consequences of this extreme monetary tightening, or they were in denial.
However, these consequences were all too clear for millions of people who lost their jobs. The economy slowed so much that it went into recession from January to July 1980.
But it wasn’t until November 28, 1980 that a bear market in stocks began. What explains the timing of the market movement then? Even now we can’t say for sure.
What is clear is that the S&P 500 lost more than 27 percent during a miserable 20-month period that ended in August 1982. If you were on the wrong side of that move, you lost a lot of money.
A premature victory
Making sense of the Fed’s plans was impossibly difficult because the Fed itself wasn’t sure how to proceed. He began to loosen monetary policy—prematurely, as it turned out—in April 1980, during Volcker’s first recession. Fed meeting minutes and contemporary Fed histories reveal that the central bank improvised. It sought to reduce “inflationary expectations” while minimizing damage to those whose livelihoods were threatened, and often did not know how to balance the two imperatives.
The effective Fed funds rate reached 19.39 percent in April 1980, only to fall to 11 percent in May and 9 percent in July. The Fed had to change course in September. By January 1981, with inflation rising, the Fed funds rate was again above 19 percent. This is not a typo.
Textbooks predict that when you raise interest rates high enough, the economy will collapse, and it did: the second Volcker recession began in July 1981 and lasted until November 1982.
Still, it made Mr. Volcker’s task easier. There was no longer any reason to doubt that the Federal Reserve was serious. Another recession? Give it! Whatever it took, as long as it stifled inflation. As William L. Silber, an economist at New York University, says in Volcker: The Triumph of Persistence: “His leadership of the Federal Reserve from 1979 to 1987 restored confidence in the central bank—almost as if he had restored the gold standard—and set the of a generation of economic stability.”
Wild trade
Trading stocks, bonds and commodities such as gold during this volatile period was exciting but excruciating. Countless supposedly well-informed “experts” recommended buying and selling stocks at the wrong time. Millions of people lost money.
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