A regular media refrain on the days stocks are down is that investors fear what the Federal Reserve will do next with interest rates. The Wall Street Journal’s Gene Colter seemed to channel this consensus in a recent column, when he noted that investors have been “fretting about whether the Federal Reserve will try to nip rising inflation in the bud by raising interest rates in June.”
The investor fear that Colter describes is likely real, but it’s arguably a bit more nuanced than he suggests. Since stocks don’t do well in inflationary environments, investors presumably don’t so much worry over Fed attempts to control inflation as they do about the manner in which it will seek to achieve those goals. Importantly, today’s media spin may be distorted by a misunderstanding of what happened in the late ’70s and early ’80s, while present investor fear might be rooted in the process by which the Fed seeks to restrain inflationary pressures.
It is now considered historical fact that the recession of the early ’80s was engineered by the Fed and was a necessary occurrence; something needed to cure the U.S. economy of inflationary pressures built up over the previous decade. But this assumption is flawed in that recessions are not a cure for inflation and that this is not exactly what happened.
On October 6, 1979, the Paul Volcker-led Fed announced that going forward, it would take a monetarist approach to monetary policy. Rather than manage the dollar with the federal funds rate, or target a market commodity, the Fed would seek to control the quantity of dollars irrespective of demand. For three years, through October 9, 1982, investors concentrated on various dollar aggregates to try and develop a sense of what the Fed would do next.
The flaw in the monetarist approach was that to work even halfway well, the U.S. needed to be a closed economy and the dollar merely a domestic currency. The reality was much different, and the monetary aggregates targeted by the Fed to maintain rigid money growth were but a fraction of the world dollar market. If the Fed sought to shrink narrow measures of the money supply (such as M1 or M2), activity in money-market accounts and the Eurodollar market (both beyond the Fed’s purview) perked up. The result was that attempts to control the narrow aggregates failed.
Worse, monetarist assumptions were flawed in the belief that demand for money was somehow stable. More realistically, the demand for money shifts all the time, meaning a growing economy requires more dollars and a shrinking one less. Practically applied, even if the Fed could have controlled the money aggregates, 3 percent growth in those aggregates might have in fact been tight amidst a growing economy, while the same money growth might have been loose in an economy that was losing steam.
With this new monetary regime in place, the economy did lose steam as interest rates rose into the double digits. Notably, interest-rate volatility surged during the time in question, something that was economically destabilizing on its face, and something that drove money demand downward as economic agents feared transacting and borrowing in a currency characterized by gyrating borrowing costs.
The dollar’s value versus gold plummeted, and by February 1980 gold had risen to $850. As Arthur Laffer and Charles Kadlec wrote at the time, “Fed policies that result in a slower growth rate of the money supply are as likely to lead to higher as to lower inflation.” Measured in gold, inflation increased despite a reduction in the monetary aggregates, given a drop in the demand for dollars relative to their supply.
Contrary to the media consensus today, the austerity that resulted from the Fed’s monetarist experiment did not arrest inflation. More realistically, the Reagan tax cuts drove demand for dollars upward. Plus, the Fed ended its monetarist experiment in October 1982 and moved toward market prices as the guide for managing the dollar. The Dow Jones Industrial Average hit a low of 743 in 1982 and never looked back.
It is widely held that if the Fed gets rates high enough today that the dollar’s value will rise and the inflation problem will be cured. This makes intuitive sense, but since markets are most useful for forecasting the future, the thinking here doesn’t necessarily hold up. Stocks underperform during times of inflation, so if nominal rate hikes were an effective mechanism for arresting inflation, stocks would by definition respond positively to rate increases if they were deemed effective.
That stocks fairly regularly fall when Fed officials float rate hikes is an argument against using rate hikes to manage the dollar’s value. Rate increases since June 2004 have occurred alongside a falling dollar, just as they did in the late ’70s and early ’80s.
Conversely, efforts to manage the dollar’s value with market prices as the guide would arguably be the gift that keeps on giving. The Swiss money supply rose 30 percent in 1978 alongside a falling price level when stable money was offered, and the same would occur here if the Fed offered investors a stable dollar measured in a commodity such as gold. The result would be more money and lower interest rates, and a more certain investment environment given Fed efforts to maintain the dollar’s value in terms of a market commodity.
As Laffer and Kadlec wrote in the early ’80s, “if the dollar were literally assured of being as good as gold, nearly everyone would hold dollars and not gold.” The Fed should take note. Rate hikes have increased, rather than decreased, the desire of economic agents to hold gold. A change in the approach to dollar stability might be what the markets are calling for.
– John Tamny is a writer in Washington, D.C. He can be reached at jtamny@yahoo.com.