The Federal Reserve is now entering a monetary easing and rate-cutting cycle in an environment of elevated inflation.
The last time this happened was during the 1970s, a decade that saw inflation spiral out of control.
The 1970s: An Optimistic Scenario
In the early 1970s, under Chairman Arthur Burns, the Fed faced rising inflation and concerns about economic growth and unemployment.
Despite elevated inflation, the Fed cut interest rates multiple times until 1972 to stimulate economic growth.
Inflation soared to over 12% in the months that followed.
In response to the rising inflation, the Fed raised rates aggressively in 1974, pushing the federal funds rate from around 5.75% to 13%.
However, as the economy entered a deeper recession, the Fed began cutting rates again in 1975 despite inflation remaining elevated at around 9%.
By the end of the decade, inflation had reached double digits again at over 11% in 1979 and peaked at 13.5% in 1980.
The raging inflation of the 1970s and early 1980s is a stark illustration of the danger of cutting interest rates in an environment of elevated inflation… such as the one we are in today.
However, as bad as the 1970s inflation was, I believe it’s an optimistic scenario.
That’s because the out-of-control inflation then was only tamed when Paul Volcker hiked rates above 17%… an option that is not available to the Fed today because of the skyrocketing federal interest expense.
In fact, the Fed could only raise rates to about 5.25%—less than a third of what Volcker had to do—before capitulating recently.
In other words, the higher the debt load, the less room the Fed has to raise rates because of the interest expense.
As the debt pile and accompanying interest expense grow exponentially, I am skeptical of their ability to hike rates to even 5.25% again; forget about higher than that.
Imagine what could have happened in the 1970s and early 1980s if Volcker could have raised rates to only 5.25% instead of over 17%.
This is the environment the US now finds itself in.
Hellbound and Down 