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Research Highlights - 11/02/2023

Research Highlights - 11/02/2023

November 02, 2023

As the US economy continues to adjust to higher interest rates, a review of prior periods of aggressive Federal Reserve rate hiking cycles is necessary. The accompanying charts detail the historical records for the Effective Federal Funds Rate, the US 30 Year Mortgage Rate, the 10-2 Year US Treasury Yield Spread, and the 10 Year US Treasury Rate. These are each fundamentally connected to not only each other, but the broader credit markets, as well as, the stock and other equity markets (like real estate).

When Paul Volcker officially became the Chairman of the Federal Reserve on August 6, 1979, the most aggressive (and prudent) activity was undertaken in modern US monetary policy history. His tenure is worth reviewing since current Fed Chair Jerome Powell highly regards Volcker's record on taming inflation. By Nov 30, 1979, the effective Fed Funds Rate had been raised to 13.96%. This was a dramatic event, since the average 30 Year Mortgage Rate was at 12.90% and the 10 Year US Treasury was yielding 10.38%. The goal was that such an aggressive boost of the Fed Funds Rate would be an effective way to smother the insidious inflation beast that had been rearing its ugly head, which by Nov '79 was at 12.61%. By Mar '80, the US Inflation Rate had peaked higher at 14.76%, while the effective Fed Funds Rate had been raised even higher to 19.85%. That's 5.09% (or 509 basis points) higher than the inflation rate. As inflation had begun to slightly wane by Jul '80 to 13.13%, the fed funds rate then was lowered to 9.57%.

Then, as if inspired by the effectiveness of very aggressive rate hikes, another two aggressive rate hike cycles followed (seeChart 1). The Fed Funds Rate peaked at 22% in Dec' 80 then was lowered to 13% by Mar' 81. By Jun '81, the fed funds rate peaked even higher at 22.26%, while inflation was even more muted at 9.55%. This bold jockeying around of the fed funds rate mystifies most economic historians. The whole cycle took nearly three years to fully control inflation. By this historical account, we're barely halfway through our current inflation taming cycle.

Our current Fed Funds Rate hiking cycle begun Mar '22. We have not seen the fed funds rate being lifted to a level higher than inflation (until only recently). Instead, when the inflation rate peaked at 9.06% in Jun '22, the effective fed funds rate stood at 1.58% - a full 7.48% (or 748 basis points) below the inflation rate. As such, many economists have been critical of the current Fed's delayed hiking action, claiming that the risk of resurgent inflation remains high. Since 1976, the average Federal Funds Rate has been 4.65% (see Chart 3), which we're currently above by only a mere 68 basis points.

If we could learn anything from Volcker it would be that taming inflation requires aggressively restrictive monetary policy. Anyone thinking that the Fed's recent inflation taming initiative looks remotely similar in size, scope, or aggression to the early '80s is not a student of Fed history (seeChart 2).