Clearly, everyone knows that we are experiencing the highest level of inflation we have in a long time — 40 years, to be precise. Last year, the Fed along with the administration sold us on the fact that inflation was transitory and would abate over time. Of course, those of us buying food and gas and paying utility bills knew otherwise. In both March and April of this year, the consumer price index came in at over 8%, with certain food stuffs up double digits and gasoline prices up approximately 50%.
To put some perspective on where we are, only twice since 1940 have we experienced inflation this high and they had the same characteristics, when supply shocks hit a robust economy. The first was in the 1950s when the economy was booming and the Korean War broke out. Mobilization and gearing up for the War created supply and labor shortages similar to what the pandemic caused today. Inflation peaked at 9.6% in April of 1951 and was back down to 1% in December 1952. The Fed tightened monetary policy and was able to avoid a recession. Let’s hope that is what happens now.
The second time that was similar to the present time was 1973. The Arab oil embargo hit our economy that was dealing with rising food prices and strong demand. Inflation hit 12.3% in 1974. The Fed raised interest rates sharply and inflation dropped slowly to 5% in 1976 and then headed higher to reach an all time high of 14.6% in April of 1980. The Fed then let market rates float freely and the fed funds rate soared to an all time high in the 19-20% range. That caused a significant recession but did solve the inflation issue. Let’s hope today’s cure is the former one like during the Korean War and not like the soaring rates experienced in the 70s and 80s which resulted in a significant recession.
If you look at the Fed’s reaction to this situation, it is interesting. Last year, they basically communicated that inflation was transitory and would abate as the supply chain issues normalized. It became fairly clear to some that inflation was rearing its ugly head last summer. The monthly increase in the consumer price index was .9% last June, .9% again in October and jumped to 1.2% this past March. As previously mentioned, the annual rate jumped over 8% in March and April. The Fed finally became inflation fighters earlier this year. Why did it take them so long?
What has the Fed actually done? On March 15, the Fed finally raised the Fed Funds rate ¼%. They followed that up with a ½% increase on May 5 of this year resulting in a ¾% rise so far this year and still under 1%. Longer term rates rose fairly rapidly earlier this year and shorter term rates need to catch up. They will still be too low to affect inflation.
Another step they have announced that they will take is quantitative tightening. For years during the financial crisis of 2008-2009, the Fed bought bonds to flood the market with liquidity, and this was called quantitative easing. The Fed balance sheet is approximately $9 trillion dollars, up from $4.2 trillion in February 2020. The Fed has basically been funding the deficit associated with the pandemic. That said, beginning June 1, they are going to start letting the bond portfolio run off as bonds mature. They are not, however, going to sell bonds.
In summary, so far, the Fed has actually done very little in its efforts to combat inflation. That said, what the Fed says is powerful. They have now talked tough for several months and what has happened? The bond market has experienced one of its worst performances ever. The stock market has been flirting with bear territory. Just yesterday, the minutes from the May meeting of the Fed were released. They talked about continued ½ point increases (probably 3 by July) and they provided details for the quantitative tightening due to take place June 1. More tough talk in the spirit of forward guidance. Financial conditions have clearly tightened without the Fed doing much.
So, what has really happened? The Fed has lowered expectations for inflation and cut liquidity in the system in the form of less stock market value, which has fallen significantly. Higher inflation primarily from gas and food prices, coupled with higher mortgage rates and the stock market decline will slow the economy and may control inflation. They have talked the economy into a slowdown. This may argue that the Fed may not have to raise rates much more after July. It will be interesting to see what happens in the next few months.
Jeff MacLellan is retired from Landmark Bank. He spent 37 years in banking, and has been tracking local economic indicators since he came to Columbia in 1987.