About the author: Joseph H Davis is Global Chief Economist and Global Head of the Investment Strategy Group at Vanguard.
In 1967, the US economy had its softest landing. Growth, which had hovered around 6% in the previous three years, slowed to 2.7% as demand for goods and services continued to outstrip supply, a development made possible by expansionary fiscal policies and the acceleration of the Vietnam War became. A year earlier the yield curve had inverted, but a recession did not follow. Remarkably, and at least in part in response to a credit crunch in the banking sector (sound familiar?), the Federal Reserve lowered interest rates in late 1966, even though inflation had recently breached the 2 percent mark that had been in place for more than a decade. The Standard & Poor’s 500 Index rose 20%.
Some economists point to 1967 as the signpost for a similar outcome in 2023. But that 1967 outcome was actually a Pyrrhic victory, a brief pause that led to a hard landing. Within a year, the economy overheated again. By 1969 inflation had risen to over 6%; the federal funds rate target was 9%, twice its 1967 level; and towards the end of the year a recession set in. Although few were aware at the time, 1967 was the starting point for the Great Inflation, the period of rising prices from 1965 to 1982, the ultimate containment of which required an 18% interest rate target. So much for soft landings.
We are not on the cusp of another major inflation. The Federal Reserve has tightened monetary policy aggressively, not loosened it. But important parallels between 1967 and today offer some lessons for policymakers and markets.
Lesson #1: Raise rates well above current inflation and keep them there. The Fed’s premature switch to rate cuts in the summer of 1967 in the face of a slowdown in growth was unfortunate. Inflation never dropped from its stable 3% level in 1967. Lowering interest rates in the face of a tight labor market opened the door to broader inflation and wage pressures within months. The history of disinflationary periods is clear: to pull the trendline down, interest rates must have been above the current rate of inflation for at least a year. With the Fed’s effective federal funds rate not yet exceeding certain rates of inflation, the summer of 1967 should serve as a reminder to the bond market that contemplating a reversal in 2023 would be ill-advised.
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Lesson #2: Minimize dependence on the unobservable. An unfortunate parallel between the late 1960s and today is the reliance on abstract measures that can underestimate the level of monetary policy that promotes a balanced economy. For the 1967 Fed, it was NAIRU, the non-accelerating unemployment rate, that suggested at the time that unemployment rates below 4% did not necessarily preclude rate cuts. In hindsight, we now know that NAIRU was over 6% back then. For today’s Fed, it’s the neutral rate, the unobserved rate at which monetary policy is assumed to neither boost nor constrain an economy. Vanguard’s internal analysis suggests that the Fed’s assumption of a neutral rate of 2.5% is about a percentage point too low and that more concrete action signals the need for higher interest rates.
Lesson #3: Balance in the labor market is key. Instead of overemphasizing unobserved concepts like the neutral interest rate or NAIRU, which are prone to significant mismeasurement, policymakers and investors can use simple, real-time measures that show the balance between labor supply and demand. One of these metrics is unique because of its simplicity and predictive power: the ratio of vacancies to the number of unemployed. For a balanced economy, the ratio should be 1:1. By the start of 2023, the ratio was nearly 2:1, a level last seen in, you guessed it, the late 1960s and a scenario sure to sustain stubborn wage inflation. In 1967, the 2:1 ratio fell only slightly before rising again. This scarcity was reflected in newspaper job advertisements. Other indicators are also pointing to a tight labor market today.
Supply shocks related to Covid-19 and the war in Ukraine have undoubtedly contributed to high inflation, just as two energy shocks in the 1970s exacerbated the challenges of the Great Inflation. But increased demand coupled with Covid-era labor market dynamics and expansionary fiscal policies have helped raise both inflation and the level of short-term interest rates needed to bring inflation back down. The job vacancy to unemployment ratio, currently at 1.6:1, clearly needs to fall further to bring inflation in line. There is little chance of escaping this compromise if we are to avoid a Pyrrhic victory like that of 1967.
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A central banker’s job is one of the toughest in the world. Fault tolerance is low and the impact of a fault can be far-reaching. Our humble recommendation to the Fed is like our advice to everyday investors: heed history, respect the future. Remain tight enough on monetary policy to ensure that once inflation is under control, it does not bounce back.
Opinions like this are written by writers outside of Barron’s and MarketWatch newsrooms. They reflect the perspective and opinion of the authors. Send suggested comments and other feedback to [email protected].
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