Fed Chair Jerome Powell—Haunted By The Ghost Of Paul Volcker—Could Tank The Economy

The new memoir by Paul Volcker: Keeping At It: The Quest for Sound Money and Good Government was written after the Federal Reserve Chair was named. At a conference in October, Powell joked that he should buy 500 copies of Volcker's book and give them to the Fed. We can all hope to live up to some part of who he is, even though I didn't do that.

Powell's tribute was a gracious one. In the 1970s and early 1980s, Volcker was most famous for helping to tame the high inflation that plagued the United States in the 1970s and early 1980s. It's not necessary to emulate that.

Powell is facing the biggest inflation spike in 40 years and some critics worry that he may be too close to an outdated Volcker model, which may cause a deeper-than-needed recession in the US and abroad. Powell has referred to the title of Volcker's memoir when discussing the duration of interest rate hikes. The stop-and-start Fed policy, led by Volcker predecessor Arthur Burns in the 70s, was a mistake because it made it even more difficult to tame soaring prices.

The key federal-funds rate, the rate at which banks lend to each other, not to consumers or businesses, was pushed to a target range of 3% to 4% by the Fed on Wednesday.

In their formal announcement, officials said they might slow the pace of hikes in December because of the lags with which monetary policy affects economic activity. In the press conference that followed, Powell didn't back away from his stance that the Fed may eventually move rates to higher levels than it projected in September.

If we over-tighten, we have the ability to support economic activity strongly. If you make a mistake in the other direction and the inflation drags on for a while, the risk is that it becomes ingrained in people's thinking. In the 1970s and early 1980s, expectations of high inflation became ingrained and workers demanded higher raises to cover future inflation.

The ghost of Paul Volcker is back at the Fed, says the founder of a consulting firm. She criticizes the central bank for backing itself into a corner by insistence that it will keep its aggressive policy until the consumer price index comes down meaningfully. "They're worried about making the mistake Volcker did in the first recession of pulling out too fast, and that's because they're in the 70s," she said. "But at this point, it's absolutely ridiculous, as there are signs that inflation is abating and inflationary expectations aren't yet becoming entrenched," he says.

He is a well-known dove. Some middle-of-the-road inflation watchers are concerned that the Federal Reserve will wait too long to slow the pace of its monetary tightening.

Ian Shepherdson, founder and chief U.S. economist of Pantheon Macroeconomics, said before Wednesday's widely-expected hike that further tightening beyond November seems unnecessary. He correctly predicted back in 2020 that rates would have to rise and early this year he predicted that housing would take a hit. There is a risk that the economy will plunge into a recession in the first half of the next decade. He says that Volcker stopped raising rates before inflation peaked.

Three-quarters of economists think the Fed will act too aggressively and cause a global recession. Powell said that no one knew if there would be a recession or not. The inflation picture has become more and more difficult this year. We have to have policy that is more restrictive in order to get to a soft landing.

Monetary policy works with long and variable lags, making it hard to judge when interest rates have reached the level needed to bring inflation down. Today's rate hike can take up to two years to fully impact the economy. It won't be until the second or third quarter of next year that the U.S. economy will see the real impact of the tightened monetary policy.

One of the reasons Greg Mankiw thinks the Fed might be overdoing it is monetary lag. Structural economic changes since Volcker's day and an already sharp slowdown in the growth of the money supply are some of the others.

Powell has shown a tendency to overcorrect for his slowness to react to inflation, and the Fed waited until prices were rising at the fastest rate in 40 years to begin hiking. Powell could not have predicted the wave of Covid that caused supply chain constraints last winter and the war in Ukraine that pushed oil prices to a seven-year high in March. The Fed's previous miscalculations that led monetary policy to be too easy for too long has made a recession almost certain. The deeper the recession, the less gain there is. The first mistake would not be canceled.

The Volcker recessions, which the majority of Americans don't remember, are not predicted by Powell's critics. After two energy shocks and years of large deficits and accommodative Fed policy, inflation ran at a 12% annual rate when Volcker took office. Volcker was elevated to the presidency of the Federal Reserve Bank of New York by Jimmy Carter because he was known as an inflation hawk. He didn't miss a beat.

Volcker decided to raise interest rates and tighten the money supply in order to keep inflation under control. After the country entered a recession, he slowed down. The federal funds rate hit a record high of 22% in the fall of 1980 as he tightened again. The unemployment peaked at 10.8% in November 1982 and was higher than the 10% peak during the Great Recession. After the Covid-19 shutdowns and recession pushed unemployment up to 14.7% in April 2020, the rate fell quickly and now sits at 3.5%.

The Fed insisted that Volcker get a bodyguard because of the threats he faced. He denounced inflation as the cruelest tax because it hit poorer people more than richer people. Inflation fell from 14.8% in early 1980 to 8.4% in January 1982 and 3.7% in the year after that.

Unemployment and the U.S. were not the only negative effects of the Volcker inflation CRACK down. The rising U.S. interest rates helped kick off a debt crisis in Latin America.

Powell has had his inflation-busting work cut out for him, but this cycle's apparent inflation spike doesn't compare to the top rate Volcker faced In a monthly survey by the New York Fed, the public still believes that inflation will fall from its current rate of 8.2% to 5.4% in a year and 2% in three years.

Employment has remained strong, but the stock market is bracing for a downturn. The S&P 500 is down 21% this year despite October gains. If the economy goes into a recession, the drop will only get worse. The S&P will tank by as much as 25% by the end of next year, according to a forecast by a global macro strategist. Goldman says the S&P could plunge another 13% to 3,400 points by the end of the year and another 19% to 3,150 over the next six months, taking a full year to recover its losses.

The S&P lost 2.5% of its value on Wednesday after markets heard Powell say that the Fed would not hesitate to take action if necessary.

The value of Americans' 401(k)s may be at stake. The pace at which the Fed is moving may eventually turn out to be too rapid. He thinks the hikes will cause the economy to go into a recession by the end of this year or early next. The unemployment rate could go up to 5.5% next year, leaving 3 million people without a job.

The result of global tightening could be worse. The United Nations warned in a report last month that the world is headed toward a recession unless the policy of monetary and fiscal tightening in advanced economies is changed.

By making the dollar stronger, this year's Fed hikes alone could cut $360 billion of future income for developing countries. The stakes are higher than in the 1970s as regions like Europe aim to support Ukraine in its fight against Russia and further cautioning the tightening could cause a global food crisis in poorer countries.

The more the Fed tightens, the more it creates these knock-on effects, domestic and international, and the more it increases the risk of a recession.

When the Fed will slow or stop its rate increases is the biggest question for economists. The team led by Goldman chief economist Jan Hatzius said in a note this past weekend that the Fed will be more aggressive in hiking rates than previously thought. The Fed projected in December that it would only need to raise rates to 3.0%.

Powell said it's not something we're thinking about and wouldn't give a specific time frame. In December, officials are expected to dole out a half-point hike, followed by quarter-point hikes in each of February and March.

It could take a large financial market disruption to cause a pause. That's such as? As yields on the 30-year Treasury leap up, policymakers could be getting more concerned about poor liquidity in the Treasury market, according to a Bank of America credit strategist. Financial stability concerns have been raised due to aprecipitous drop in housing prices, which could result in too much tightening in the housing sector, a key part of the U.S. economy.

It is not yet known when the Fed will pause or pivot. According to Fed officials it may take a while.

The idea that the Fed keeps pushing back on the pivot is comical because they've been transparent. I would take them at their word that they needed to get to restricted territory and stay there for a while.