Mark Lister, 17 June 2022

With a few cracks appearing in the global economy, we might soon find out just how far central banks are willing to go to knock inflation on the head. Jerome Powell, Chair of the US Federal Reserve, is in a particularly difficult position.

In May, the US consumer price index (CPI) rose at an annual rate of 8.6 per cent, above forecasts and the highest since December 1981.

Higher prices for food, gas and energy all contributed to the gain, while shelter costs (which account for about a third of the CPI) posted the biggest annual rise since February 1991.

subscribe banner

With the US labour market still tight, wage pressures are building and contributing to the price pressures elsewhere.

The Atlanta Fed's wage growth tracker increased to 6.1 per cent last month, the highest reading since it started publishing this in 1983. This will be making policymakers increasingly nervous about the dreaded wage-price spiral.

At the same time, we’re starting to see signs of the toll this is taking on the US economy. The University of Michigan Index of Consumer Sentiment fell to 50.2 in June, the lowest in the history of this survey (which started in 1978).

Earlier this week, the Fed hiked interest rates by 0.75 per cent, the biggest move since 1994. That puts the US policy rate at 1.75 per cent, below our own OCR and also what is considered “neutral”.

Powell still has plenty of work to do, and from here the decisions could become increasingly difficult.

He will be starting to ponder how he wants to be remembered, when future historians look back on his tenure as the head of the world's most influential central bank.

Two of his predecessors’ spring to mind - Arthur Burns and Paul Volcker.

Burns was Fed Chair from 1970 to 1978, and he is remembered as being too soft on inflation.

He believed monetary policy was too broad of a tool to fight inflation, and when he took office he responded to the 1970 recession by cutting rates.

Inflation was moderating at the time, but it rose again when oil prices surged in 1973 in the aftermath of the Yom Kippur War. The Burns-led Fed hiked rates again, but cut them when the second recession of the 1970s hit (even though inflation kept rising).

Burns was adamant inflation was being influenced by one-off factors that should be ignored. He insisted the Fed exclude oil from the CPI basket, then he asked that they remove food as well when unusual weather events appeared to push crop prices up.

This was the genesis of what people today refer to as "core inflation", which usually excludes food and energy (despite these being essential to almost every consumer).

Stephen Roach, former chief economist at Morgan Stanley, started his career at the Fed in 1972 and later described this dogmatic thinking from Burns as “a blunder of epic proportions".

He eventually acknowledged his mistakes, although by then it was too late. The horse had bolted.

Soon after came Paul Volcker. Volcker was Fed Chair from 1979 until 1987 (when he handed the reins over to Alan Greenspan) and he proved to everyone that central banks do have the power to tame inflation.

In the first year of Volcker’s tenure the US inflation rate hit 14.8 per cent, so he cranked interest rates up to 20 per cent in response. That took its toll on the economy, and it pushed unemployment to over 10 per cent within 18 months.

He made plenty of enemies along the way, but Paul Volcker beat inflation. It was below three per cent by 1983 and the US economy rebounded to enjoy a very strong expansion during the rest of the decade.

There are some interesting parallels with the 1970s and today, including the war in Ukraine, the spike in oil prices and the dithering from Powell and the Fed for much of last year.

They’re making amends, having pushed through some aggressive interest rate hikes over the past few months, but it remains to be seen how they will react if the economy starts to deteriorate, but inflation remains stubbornly high.

Hopefully, Powell won’t buckle like Burns. If he can hold his nerve and deliver up a bit more pain, he might avoid having to go full Volcker-mode on us later.