An analysis of interest rates, the yield curve and inflation in the 1970s and how they compare to today's situation, and what lessons, if any, Uncle Benny could learn from Granpa Volcker.

http://www.debtorsprisonblog.org/journal/2009/12/10/how-would-todays-superinflation-compare-with-the-1970s.html

Greetings Fellow Inmates,

It is no secret that we are staunch believers that Uncle Benny and Co’s wild monetary adventures will result in massive inflation down the line. To describe the inflationary effects that are likely to result from such monetary expansion we have often invoked the term SuperInflation, which we have defined as a Consumer Price Index (CPI) reading of 25% annual change, irregardless of how long it stays there. For some context, this has only happened 3 times in the history of the US, and only briefly each time. In traditional economics, it’s all about timeframe; it is said all you must do is wait long enough and you will always be correct. For that reason, we have also given a timeframe over which we expect SuperInflation to happen, within 2-3 years time. Clearly, at the moment, regulators, the media and some portion of the public are more concerned about the prospects of deflation. In the near future, we will do a post on the whole deflation/inflation debate from a Hegelian perspective. The purpose of this post is, instead, to hypothesize about what would happen if SuperInflation does indeed come to pass, as we expect it will. Specifically, we will be looking at the interest rate/yield curve because a) the potential, implicit solution to such SuperInflation is raising of interest rates and b) the magnitude of our sovereign debt problem makes it quite likely that SuperInflation would be intimately linked to sov debt crises/currency collapses.

We will begin this discussion by comparing today’s situation with a relevant historical example. As we have said recently, history can be useful if at least to glean some perspective into what is possible. Of course, circumstances, underlying causes, their interrelationships and correlated forces might make for a different outcome, but the historical comparison is still worthwhile if taken with a cautious tone. We will proceed with the following historical comparison since, again, it is implied not only by economics, but by policy makers alike (with their vague and shapeshifting statements on risk management) that raising interest rates would still be the primary tool used to combat any potential run-away inflation. There isn’t a man on Earth capable of striking the fear of death into inflation’s little heart more than Granpa Volcker, whose chairmanship at the Fed in the early 80’s was credited with ending the run-away inflation of the time. In this post, we will examine the “actions” Granpa Volcker took to combat soaring CPI readings as well as the circumstances surrounding such actions – and what lessons, if any, Uncle Benny could learn if it ever came time to combat inflation on his watch. As an administrative note, Granpa Volcker has the honor of being the first Enforcer in our newly titled section “The Enforcers”. This new page will feature very prescient, succinct and relevant biographical information about the most noteworthy players in this global debt prison. Many a-time, only a bit of research into the personal lives of decision-making people can yield wonderful insights into their motives, biases, associations, interests and inclinations. Not only do we promise to never waste your time with trivial, uncorroborated or speculative biographical facts, but we also highly recommend you spend some time reading the bio sheets and perusing the links contained therein.

Back to the post. Let’s begin with some basic premises. The Fed Funds Rate is the primary tool the Fed has used historically to exercise monetary policy or, in other words, to affect the “value” of money. Managing monetary policy through a short-term rate, such as Fed Funds, is equivalent to affecting the price of money. As the interest rate rises, it becomes more expensive to borrow money, decreasing the abundance of money, thus eventually decreasing inflation since there is less money chasing an (approximately) fixed quantity of goods. At least, that is how it is supposed to work. The yield curve is the term structure of yields on government bonds or, in other words, the linear sequence of yields charged on government bonds of different maturity. Under “normal” circumstances, all else being equal, one expects yields on long-term debt securities to be higher than short-term ones. This makes perfect sense, since we remember that a yield is the same as an interest rate. The longer the loan, the more risk to the creditor, hence they demand a higher interest rate. In other words, the lender/creditor is compensated for the time risk. Sovereign yield curves certainly show this property most of the time, except when they are said to be “inverted”, or downward sloping, which is when long-term yields are lower than short-term ones. Let’s say the yield on a 3-mo US Treasury (3m UST) is 5%, but the yield on the 10-Year US Treasury (10Y UST) is 3%, then The Market is expecting that in the next 10 years, interest rates will be lower than they are today. Presumably then, an inverted yield curve signals or predicts an upcoming period of expansive monetary policy. For this reason, inverted yield curves have traditionally been used as leading indicators of recessions, or at least economic deceleration, since The Market expects that in the future, monetary spigots will need to be turned on so to buoy a sagging economy.

With these basics in mind, we can proceed to scrutinize Granpa Volcker’s reputation as a swashbuckling, inflation-squashing central banker – and any lessons Uncle Benny could take away. We have aggregated a bunch of historical data on the yield curve, fed funds, and CPI from Uncle Benny’s archives. You can download all the following charts and data here, we have color-coded and commented on relevant trends for easy digestion, we highly recommend the download.

Below is a chart that compares the yield curve “steepness” - simply defined as the difference between 10-year yields and 1-year yield (10Y Yld – 1Y Yld), CPI and Fed Funds. The data ranges from 01.01.1966 to 07.11.1983. The long-term graph really does tell a very interesting picture filled with noteworthy details we comment on below



The inflation story begins in 1977. CPI began a 30-month rise that would take it from 6.4% (10.1.1977) to 14.8% (03.01.1980). Naturally an 8.4% rise in annual CPI is a whopping amount, even over a “baseline level” of 6.5%, which is substantially higher than our current alleged preference for a 2.0% annual CPI. Quite interestingly, in the beginning of ’77, Fed Funds began what would be a 39(3x13)-mo rise that would see it rise exactly 13.00% from 4.61% (01.01.1977) to 17.61% (04.01.1980). So, it is interesting to note that the very long, deep and consistent rise in Fed Funds preceded, or anticipated, the rise in inflation by 10 months. Moreover, it is worth noting that Granpa Volcker entered office only in August 1979, so he was only responsible for exactly 6.66% of the total rise in Fed Funds, or roughly about 51.23% of the total rise. So, while he is certainly the majority (by a slim margin) author of the Fed Funds rise credited with breaking inflation’s back, he owes much credit to his much less-famous predecessor, dead, Great-Granpa Willy. Please take a moment to consider that the increase in Fed Funds began 10 months BEFORE the CPI began rising. This clearly invalidates the notion that Fed Funds Rate increases of the late 70s were undertaken as a response to rising CPI. They incontestably anticipated a rise in CPI. Of course, it is possible to envision a situation in which the Fed, or other, could anticipate a impending rise in inflation and pre-emptively move against it. One would only need a realistic measure of the velocity of money, or rather the amount of ­time-lag between the expansion of the monetary “bases” and the ensuing expansion of the broad monetary aggregates that lead to a rise in CPI. Naturally, this is dependent on the money multiplier model working, which as we discussed a while ago in What if the Money Multiplier Model Doesn’t Work?, is highly unlikely. But for brevity’s sake we will neglect this difference for now, since, after all, that is what the Ancient Clan of Wizards wants us to believe anyway.

Back to the story. In September, 1978, right after Great Granpa Willy raised the Fed Funds on 23 straight months by a substantial 3.84% AND 13 months after CPI began rising, the yield curve inverted. In other words, The Market, began believing that the then-current Fed Funds Rate was “too high” and would have to come down from those levels in the long term, within 10years. It could also be argued that the yield curve inversion anticipated the period of economic stagnation that would follow for the next 5 years. The yield curve would remain largely inverted for the next 54 months. So Granpa Volcker comes in on hard knocks, sent to combat a two-year rise in CPI, a year-long inverted yield curve, which was telling him he should already by thinking about cutting rates eventually. Immediately after entering office he raises the Fed Funds by 6.66% in 10mo, and then proceeds to act very erratically thereafter. Nine months after his inauguration, the CPI finally began to drop. This would actually prove a turning point, as CPI would proceed to drop over the next 16 months a total of 5.2(4x1.3)%, and an ultimate drop of 12.3% in the following 39(3x13)months. Immediately after CPI began to drop, before it could be determined if it was a fluke or a real turnaround, Granpa Volcker proceeds to massively slash the Fed Funds, a total of 8.6 (1.3x6.66)% over the next three months. Yet, after his early, irrationally large, and unsubstantiated move to cut rates, he then proceeded to raise rates even beyond earlier levels, to record levels, in the next 10 months. This, in spite of the fact that CPI continued dropping during this whole time. The Market even began telling Granpa Volcker that rates were too high, since even 1-year yields were lower than Fed Funds. In other words, The Market was saying, “Hey, Granpa Volcker, chill out, inflation has begun receding for the past 6 months. You better cut rates within the next 12mos or else!” Coincidentally, he finally cut rates almost exactly as CPI ended its 16mo decline. So, after an initial splurge, in which he threw money around like a drunken sailor, premature in proclaiming the end of inflation, then he made a quick about face and raised rates for nearly a year and a half, IN SPITE of evidence of declining CPI. And then, once he finally decided to cut rates, CPI began rising again. Granpa Volcker acted erratically through the rest of his term, keeping interest rates high (above 5%), in spite of really low CPI readings at times. So, in other words, we would characterize Granpa Volcker as a wild loose-cannon instead of a resolute monetary tightwad responsible of a reduction in inflation. Grandpa Volcker was mean, he was wild, volatile and at times acted in contrary to what The Market and evidence would tell him.

This brings us back to today. Remember, we are hypothesizing about the possibility of a disruptive wave of inflation in the near-future, more precisely a CPI reading of 25% within the next 2-3 years. For comparison, the highest CPI Granpa Volcker ever saw was only 15%. In other words, we expect SuperInflation will be at least 66.6% worse than the most recent earlier example of distruptive inflation. Here is a chart with the current US Yield Curve, courtesy of BloomBerg (BB1).



So what is the yield curve telling us? Well, for starters, it is anticipating that interest rates (Fed Funds) will remain below 1% for the next two and a half years. Think about this, a 1% Fed Funds is very low; it is the level to which Judy Greenscam is widely criticized for lowering Fed Funds, thus fuelling the housing bubble that got us in this current mess. The YC also anticipates interest rates will remain below 3% for the next 7 years. Alright, to put this in perspective, in the 8-year reign of Granpa Volcker, Fed Funds never dropped below 5.85%. Yet the yield curve now predicts we will stay below 3% for the next 7 years. In fact, it predicts that not even in 30 years will we reach 5% again in the Fed Funds. Seen in a very broad perspective, it can be easily deduced that the bond market is in no way worried about inflation for the next 30 years. Wow, how stupid. Well, Mr. Carville, we for one are not intimidated by something so stupid. Think about it, in a way, the bond market currently assumes that CPI will not rise above 5% in the next 30 YEARS. Either that, or it believes that people will continue buying US Treasuries even at negative real rates, meaning the whole world will agree to continue investing in something that for the next three decades is surely to erode wealth, as it fails to keep up even with inflation. In either case, it is delusional. But we’ll discuss that, market efficiency, and other popular follies in future instalments.

Another couple of interesting background points for our current situation. The Yield Curve once again inverted in 01.01.06, thus predicting the current recession. In other words, this marks the beginning when the Market became aware of the coming problems and that interest rates would have to be reduced as a consequence. In April, 2006, a mere two months after Uncle Benny came to office, The Market began telling him, and has continued to tell him for the next 34 months, that the Fed Funds rate was too high, and that we must lower it within 3m or else! Though he held out for about a year, Uncle Benny has been overwhelmingly compliant ever since. His notorious overwhelming proclivity for wanton monetary expansion makes it very difficult for us to ascribe him the resolve to raise interest rates as necessary once SuperInflation hits. Even if he did want to, he has worked himself into a corner with quantitative easing, which has meant lowering the Fed Funds to zero and purchasing a lot of long-term US debt. Bear in mind that in order to regain control of the Fed Funds Rate, the Fed Balance Sheet (FedBS) must first be shrunk significantly, which means selling a lot of long-term debt securities, which will invariably mean higher long term yields. In that case, The Market YC would be telling Uncle Benny that he better prepare to raise interest rates significantly above current levels in the long-term future. In other words, even before regaining control of the Fed Funds rate, Uncle Benny’s sales of long-term US debt will create a situation equivalent to one where the Market becomes concerned about inflation down the road. At that moment, Benny must begin to think about the possibility of raising interest rates. In order to regain full control of the Fed Funds Rate, Uncle Benny must unload a huge amount of long-term USTs and MBS debt. Given as the Fed has recently become the largest market for new-issue USTs, Uncle Benny’s sales could result in much higher long-term rates. So, the market would tell him to expect to raise interest rates significantly within the medium term. We could easily see the 7-Y yield at 5%, versus 3% today, if not much, much more. If SuperInflation does indeed come to pass, would Uncle Benny be ready or even capable of interest rate hikes of the magnitude and timing necessary ? Doubtful.

So, what would we say to Uncle Benny now? Mainly two things. One, if SuperInflation comes your way, don’t act like Granpa Volcker. Two, can you please for the love of God and Reason (GR) realize that you have lost all control over mid and long-term interest rates? Can you please realize Uncle that the bond market, as reflected in the yield curve, is completely out of whack with the monetary reality you are bound to create or require in the next few years? In effect, you, Uncle Benny are nothing but a shadow and vacuous conductor to an orchestra-cum-cacophony that long ago stopped listening or following your cue. You don’t even control the broad monetary aggregates, but rather merely follow them, how pathetic. Then, please, please just stop waving your fruitless little hands in the air, and just tell me what you know. What is happening at the margin, at those Fat, Dark Wings (corners), where all the important stuff happens? The puppet-show of “policy debate” publicly displayed for us slaves is not only intentionally misleading and dilatory, but is often divergently different from the economic and financial reality, even as discussed in the same inner echelons of power that produce the puppet show. So, Uncle Benny, rather than really concern ourselves with what you will do with your vestigial little tool, the Fed Funds Rate, which you continue to render more and more meaningless by the day, we would rather prepare for the potential risks. Inflation can be a ruthless enemy and we are firmly convinced you have not only planted, fed and nurtured the seeds of SuperInflation, but will also be powerless to stop it, it will eat you alive and not even 6 foot 7 Granpa Volcker will be able to resuscitate you with one of his many powerful Black Incantations.

As for you dear readers, may your capital be safe and your investments prosperous,

MAAA