“Whoever controls the volume of money in our country is absolute master of all industry and commerce … when you realize that the entire system is very easily controlled, one way or another, by few powerful men at the top, you will not have to be told how periods of inflation and depression originate.” - James A Garfield
Inflation, in the basic sense, is a rise in price levels. Economists believe inflation comes about when the supply of money is greater than the demand for money. Inflation is viewed as a positive when it helps boost consumer demand and consumption, driving economic growth. [1]
Inflation is one of the greatest threats to a healthy economy. Inflation eats away at our standard of living if our income doesn't keep pace with rising prices over time. This means that the cost of living increases and a high inflation rate can hurt the economy.[2]
One of the worst periods of inflation this country faced was in the 1970s. The video, “Money for Nothing,” discusses how the Fed bowed to political pressure and refused to raise interest rates as they should have to pay for the costs of the Vietnam War and War on Poverty. At the time, the gold standard limited the government’s ability to print more paper money unless they had enough gold to cover it. The government didn’t have enough gold, and they couldn’t print more money. So, this made existing dollars more scarce, and in turn more expensive.
For example: The “cost of money” as reflected in the interest rates banks pay the Fed for overnight borrowing increased from 3.0% in 1967 to 6.2% in 1969.[3] The current Federal Funds rate “target range %” is 00.0 – 0.25.[4] At its meeting next week, the Fed is expected to raise this rate by .25 - .5%. The large difference between 1967 and today is about 2.5%. If the Fed tried to make up that type of gap in historical rates, they likely would put the U.S. economy and different other world economies tied closely to the Fed’s rate, into a large market “crash.”
On August, 1971, President Nixon announced a halt the convertibility of dollars to gold. Up until then, a person could theoretically walk into a bank and exchange her dollars for gold.[5]
Breaking the dollar’s tie to the gold standard allowed the government to print “all” the money it needed, backed only upon the full faith and credit of the US government to repay. In 1973, the president scrapped the gold standard altogether.[6]
In addition to dropping the gold standard, Richard Nixon also imposed harmful wage-price controls. That move bypassed America’s free-market economy and ultimately helped cause the hyper-inflation in the mid-late 1970’s, and led to a decade of stagflation (a combination of stagnant economic growth, high unemployment, and high inflation).[7]
Stagflation will be a separate topic in an upcoming report, but bottom line: bad policy decisions by the Fed could drop us into stagflation, which likely have a more serious long term effect on our economy than a short recession. The Japanese lost the decade of the 1990’s to stagflation. That is why some knowledgeable people suggest looking at inflation on a decade by decade basis, rather than its rate in any given year.
Looking at the effect these moves had on the buying power of the American dollar … it’s worth pointing out that what cost $100 to buy in 1971 now costs $654.75 in 2021.[8]
In 1974, Gerald Ford announced a national “Whip Inflation Now” campaign, aimed at combating inflation by encouraging personal savings and disciplined spending habits in combination with public measures. “The campaign was later described as "one of the biggest government public relations blunders ever".[9]
Ford lost re-election in 1976 to Jimmy Carter. Carter named Paul Volcker Fed Chairman on July 25, 1979. Volcker’s Fed took tough, unpopular, but ultimately effective policy steps, aimed at contracting the money supply rather than targeting interest rates. “The days of “easy credit” turned into the days of “very expensive credit.”[10]
During the ensuing months, inflation peaked at 14.8% in March, 1980 and the prime interest rate rose to 21.5% in 1981. Unemployment rose to over 10%. The Federal Funds rate rose to 18.33% on June 8, 1981 from 10.61% on July 16, 1979. It then started dropping: to 12% in 1981, and then to 8.5% in 1982 and to 6.75% by 1986.[11] [12]
Arguably, Volcker’s Fed served as a foundation for a growing economy during the first seven years of Ronald Reagan’s presidency. Although Reagan’s economy reaped the benefits of Volker’s tough stance of controlling inflation by “withdrawing the money supply” (i.e., raising interest rates), he was fired as Fed Chair by Reagan on August 11, 1987 because his administration “didn’t believe he (Volcker) was an adequate de-regulator.”[13]
Monetary Policy and the Fed
Investopedia.com states that “If a nation’s economy were a human body, then its heart would be the central bank. Just as the heart works to pump life-giving blood throughout the body, the central bank pumps money into the economy to keep it healthy and growing.” This is known as Monetary Policy. Our central bank, The Federal Reserve, or Fed, has several methods to control the amount of money in circulation in our country. They include influencing interest rates, the setting, or changing, of bank “reserve requirements” and the printing of money to help fund government approved programs like the trillions spent on several Covid 19 economic relief programs.
For example:
On March 26, 2020, in response to the coronavirus pandemic, the Fed reduced reserve requirement ratios to 0%—eliminating reserve requirements for all U.S. depository institutions[14]
Using these tools, and depending on whether the Fed is in an “expansionary” or “contraction” mode, they can make it easier, or more difficult, for individuals and companies to borrow money. The Fed can also affect the quantity of money in circulation by buying or selling short-term Treasuries and other securities through the NY Fed in the open market, rather than the US Treasury. This process is known as open market operations (OMO).[15]
When the central bank buys government securities from commercial banks and institutions, the cash payments that these institutions receive from these sales give them more money to lend out. In this way, the “hope” is that they will lend to borrowers and help stimulate the economy.
This is not always the case, as the housing bubble crash in 2008 showed some banks keeping the cash to shore up their required reserves and balance sheets. When this occurs, the Fed has other “tools” in its arsenal to help stimulate economic growth.
When the Fed wants to take money out of the economy, they simply adopt opposite policies to the above. Sometimes, like now, more than monetary policy is required. To try to keep the economy going through the pandemic, our government has also had to pass spending legislation, a.k.a., Fiscal Policy. Suffice it to say, the Fed cannot approve spending policies.
Epilogue: Currently, interest rates are at a 40 year high and rising. This is one of the results of too much “easy” monetary policies for too long. Like 2008, when the Fed pulls the “punch bowl” of “money for nothing” the party can suddenly be over. For example, Fed reserve requirements for banks was reduced to zero on March 15, 2020, asset prices from investments to housing soared, and trillions of dollars have been paid out for the CV-19 stimulus packages has fostered bad behavior. Now we must start repaying the price, and the cost of that repayment is called higher, and rising, “inflation.” Until people are stopped from excessive buying of scare goods and services by interest rates reach an “unaffordable” point, higher inflation can be expected.
The Fed now claims it will start withdrawing “punch bowl” type stimulus programs, and focus instead on attacking inflation by controlling the amount of money available for people to spend. In the March 11, 2022 WSJ an article entitled: “ECB Plans Quicker Departure from Bond Buying Program” points out that the European Central Bank is mirroring Fed actions by phasing “out its large bond buying program sooner than expected and paved the way for interest rate increases this year … underscoring the challenge that Europe faces in managing the potential stagflationary shock caused by Russia’s war in Ukraine.” It goes on to state: “Trying to stabilize markets while simultaneously reining in inflation creates a target conflict … Ultimately, one has to give.”
One may want to reconsider whether the hyper-inflation of the 1970’s and 1980’s can’t return. If it does, given current world geo-political events and their tremendous ripple effects going on around the world, we all likely will have to rethink about the implications for our personal financial well-being. What happens if gas jumps to $7/gallon?
Frank Deptola | President, M.S.T., M.B.A.
Frank Deptola & Associates, LLC | 2400 E. Katella Ave., Suite 800, Anaheim, CA 92806
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