Higgins: There are three common questions that I've heard over the past few months, and I've listed them out here. The first is, why did the Federal Reserve fail to contain inflation in the 1960s and allow stagflation in the 1970s to happen in the first place? The second, and one that I cannot possibly answer precisely, is, how likely is a recession in 2022 and 2023, and how severe will it be? And my short answer to that is it seems very highly likely, but it’s out like it did in in 1920 and 1921. It’ll be maybe a little deeper than people hope, but probably a little quicker than people fear. And then, finally, I've heard this many times over the past several months. People ask why they should avoid tactically allocating their portfolio if it seems likely that a recession and further asset declines are forthcoming. And in a lot of papers I wrote, why did I advise people not to do that? And we'll get into some of the answers there.

On October 9th, 1979, former Chairman of the Federal Reserve Board Arthur Burns gave a brilliant speech in Belgrade Yugoslavia explaining why he failed to contain inflation during the 1970s.


The speech is sort of a famous document at the Federal Reserve. It's called “The Anguish of Central Banking.” And Paul Volcker, believe it or not, was actually inthe audience taking notes for this speech. In his speech, Burns revealed all ofthe major causal factors behind the Federal Reserve's blunders during his time as Federal Reserve chair, which lasted from 1970 to 1978. One of the most revealing quotes was when he said: “‘Maximum’ or ‘full’ employment, after all, had become the nation's major economic goal—not stability of the price level … Fear of immediate unemployment—rather than fear of current or eventual inflation—thus came to dominate economic policymaking. At any time within that period, it [the Federal Reserve] could have restricted the money supply and created sufficient strains in financial and industrial markets to terminate inflation with little delay. It did not do so because the Federal Reserve was itself caught up in the philosophic and political currents that were transforming American life and culture.”


In the book that I'm publishing this year, I use this quote to open the subchapter that explains why the Great Inflation happened. I then explain the four primary drivers, the most important of which, in my opinion, was political influence on the Fed and a weaker sense of independence among the Fed leadership. And Arthur Burns clearly references this in the quote. I do want to go through all the major drivers at a high level, though.



The first driver of the Great Inflation was a strong bias at the Federal Reserve toward maximum employment rather than price stability. As most of you know today, the mandate of the Federal Reserve is to balance these objectives, which pretty much conflict with each other most times. This simply just wasn't the case during the Great Inflation, and there were two primary reasons for this. First of all, in the late 1960s, the horrific experience of the Great Depression, which you see a picture of people out of work on this page, was still lingering, and the scars were still lingering in the minds of many Americans. During the Great Depression, unemployment peaked at almost 25% and then remained in the double digits for the entirety of the 1930s. And this is just not something that is an emotional scar, if you went through this, that disappears quickly. Many Americans, again, were understandably scarred by this. And any sign in the ’50s and ’60s that unemployment could creep up to those levels, the government and the Federal Reserve wanted to extinguish that as soon as possible.

The second reason was that many politicians interpreted language in the Employment Act of 1946. They interpreted this act as mandating that the federal government needed to maintain full employment at all times. And the strange thing is that the language also does reference price stability in it, but it's kind of buried at the bottom of the paragraph. And at least, the interpretation was that promotion of full employment should take precedence over price stability.


In the 1960s, economists estimated that 4% was the natural rate of unemployment, meaning that this represented the rate that was normal, just given people leaving jobs and changing jobs, people being terminated from jobs, just kind of frictional unemployment that was normal for an economy. It turned out, in retrospect, that the 4% number was much higher than retrospective estimates of the natural rate at the time, which was about 5 or 6 percent.


So, bottom line, economists inaccurately estimated the natural rate of unemployment, and the federal government and the Federal Reserve believed that their primary responsibility was to ensure that full employment was maintained at all times. This was a very unhealthy recipe for inflation, and that was a big driver in the onset of the Great Inflation.

The second driver—and I would argue that this was the most important driver—was intense political pressure to prioritize maximum employment over price stability. There are very few bipartisan political philosophies in U.S. history. We’ve often been a divided nation. But in the 1960s and 1970s, members of both parties prioritized, clearly, unemployment over inflation. Neither was shy about putting pressure on the Federal Reserve to concur with this perspective. Just as a couple of examples, in September 1965, after William McChesney Martin Jr., the Fed chair who served from, actually, 1951to 1970, suggested to President Lyndon Johnson at his Texas ranch that either budget cuts or interest rate increases were necessary to tame inflation. And President Johnson responded by yelling at Martin and pushing him against the wall and saying, “My boys are dying in Vietnam, and you won't print the money I need.”


Nixon was not much better. Arthur Burns repeatedly recommended tightening monetary policy in order to tame inflation. And in one conversation in 1970, Nixon stated, just to kind of indicate where he stood—which his administration backed him on—was, “Domestically, we should err on the side of too liberal monetary policy. Arthur, inflation was awful, but it was better for politics than unemployment. We should risk some inflation.” And this was the mentality that carried over into the Nixon administration. The Fed, of course, caved to this pressure. And to some extent, it's hard to blame them, because the American public was much less concerned with inflation also. And they pretty much coordinated Fed policy with the policies of the executive branch.

: The third driver was the Federal Reserve's mistaken belief that the tradeoff between unemployment and inflation was stable. This is a little more complex to understand. But essentially, what you see here is a relationship that's commonly referred to as the Phillips curve. And the way this works is, you see on the X-axis there's the unemployment rate—high rate on the right, low rate on the on the left—and then inflation rate on the Y-axis, with low inflation toward the bottom and high inflation toward the top. Essentially, the tradeoff is that as the unemployment rate goes lower, workers have more pricing power in their wages, so inflation goes up.


And what the Fed did not realize, however, is that this curve would adjust. If you have unemployment that drops below the natural rate, it pushes inflation up. But eventually people just kind of get used to that level of inflation. Unemployment returns backto the natural rate. And then, the next time the Fed seeks to reduce the unemployment rate by loosening monetary policy, the inflation rate goes one step incrementally higher. In other words, the curve shifts upwards.


So, essentially, what was happening in the 1970s was that each time the Fed loosened monetary policy again to reduce unemployment beyond the point which they should, a new higher rate of inflation would set in. This kind of just incrementally kept going up and up and up. And this vicious cycle essentially continued throughout the 1970s, until the Federal Reserve tightened monetary policy aggressively under Chairman Paul Volcker and finally broke the back of what was the hardest to break the back of, which was higher inflation expectations.


And then the final driver was an absence of an inflation target. As many of you know, the Federal Reserve today has a discrete target of 2% inflation in the long run. The Federal Reserve just didn't have that target in the 1960s and 1970s. So, if you don't have a target to shoot at, kind of difficult to achieve a functional strategy for managing price stability. We'll discuss this in greater depth in the next class, but one of the key elements of Volcker’s plan was establishing a firmer inflation target and a specific target for the money supply. And one of the reasons today that you see the Fed having a 2% target does stem from the costs of not having a target back in the 1970s.

All I can say to this is that it's impossible to predict the future with certainty, but the prospects don't look good. And what you see on this chart is first a line graph that's linked to the left axis. The blue line shows the trailing 12-month inflation rate for the 37 months since the end of World War I and the Great Influenza in December of 1918. The blue bars, which are linked to the right axis, show the cumulative interest rate increases by the Federal Reserve. You can see that inflation—and the economy, which we'll get to—went off a cliff after 20 months.


Now, the red line shows the trailing 12-month inflation rate for the 17 months since the end of COVID-19, the peak period of quarantine in April 2021. The red bars show the cumulative interest rate increases by the Federal Reserve so far. Right now, we are right about at the point where disinflation startsand the economy enters a recession. This is a pretty ominoussign. My personal opinionis that it's highly likely that we will enter a recession soon.

This is actually a pretty good question. It’s one I’ve thought about a lot. But the answer is that markets can snap down or snap back so fast and so unpredictably that even if you have a good sense of where the market is going, it can be really difficult, if not impossible, to get the timing right. And you have toget it right twice. You have toget it right when you get out of the market, and you have toget it right when you get back in.


Commenting on just how difficult this process is, Paul Volcker himself had a great quote to explain how hard it is to time the market. He said, “There is a prudent maxim of the economic forecaster’s trade that is too often ignored: Pick a number or pick a date, but never both.” And to illustrate this, there's a chart at the bottom of the page that shows the total return of the S&P 500 from 1930 to 2020, so 90 years, and what you would get if you just were in the market the entire time, which is a pretty enormouscumulative return—almost 18,000%—and what you would have gotten if you missed just the 10 best days of the decade. And you basically got nothing, at 28% return over that period.


So, this just illustrates the potential impact of tactical allocation. Obviously, you're not just going to miss the 10 best days. But the point is, markets can move very, very quickly, and it's very hard to time the market even if you do have a better sense of what's coming in the future. So, that is my quick and dirty answer to the question of tactical allocation, and those are the three main questions that I've been receiving over the past few months.

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