Volcker Shock Therapy

Fighting inflation with a double-edged sword

History doesn’t repeat, but it often rhymes.

- Mark Twain

Inflation levels are the highest they’ve been in more than 40 years. The pressure is mounting on the Federal Reserve to do something about it, and sure enough, they’re moving fast - After Jerome Powell approved rate hikes in March, he’s gone on to greenlight even 50 base point rate hikes, and interest rates might shoot up much faster than expected.

But this isn’t the first time something like this is happening. Looking at the direction we’re heading in, we might be in for a phenomenon that we haven’t seen in close to 50 years - A Volcker shock.

So this week, let’s dive deep into what the Fed’s job is, peek at their track record, understand why a Volcker shock is such a big deal - And most importantly, what it means for your money!

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The Federal Reserve

What does the Federal Reserve do? Contrary to what some might think, the Fed’s job is not to make the market go up so that you can post your profits on Wallstreetbets. The Federal Reserve is a “Central Bank” whose role is to oversee the economy, regulate financial institutions, and control the supply of money in the system. Their priority is to make sure that the United States has a strong labor market, maximum levels of employment, and low levels of inflation. But

Because it’s the single most influential financial institution in the country, every major decision taken by the Federal Reserve has an immediate - and sometimes lasting - impact on the market. We’re seeing this happen right now.

With inflation surging 8.5% in March to a 40-year high and energy prices soaring while wage levels have not been able to keep up, the Fed is under pressure to reign in inflation. On March 16, the Fed approved its first rate hike of 0.25% - Even though this seems small, the market tumbled immediately in reaction to this, and mortgage rates shot to 5%. Now there’s more news that we might see 0.5% hikes through the rest of the year! There’s no telling what might happen… Or is there? Let’s wind the clock back a little.

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Stagflation - and the Volcker shock

After the Second World War, there were fears of a depression looming over the US because 12 Million military personnel were coming home and defense spending would be slashed. The solution? The Employment Act of 1946 was drafted, and it prioritized “maximum employment, production, and purchasing power.” This drive to make sure that everyone had a job came at the cost of something else - You guessed it, stagflation.

When President Nixon ran for re-election in 1973, he pushed for low interest rates to bolster the economy. Though this helped reduce unemployment, inflation started to increase and other countries began to panic and redeem their US Dollars for gold. The final stroke was when the Gold Standard was dropped. Prices began to skyrocket. In 1973, inflation more than doubled to 8.8%. By 1980, inflation was at 14%! But even though prices were rising, economic growth was very slow, and wages weren’t catching up, leading to stagflation. This is when Paul Volcker stepped in.

Inflation (Blue) vs Unemployment (Red) | Source: FRED Economic Data

Paul Volcker was appointed as the chairman of the Federal Reserve and he was tasked with the goal of bringing down inflation. He did this by limiting the growth of the nation’s money supply - As money became scarce, banks would raise interest rates and limit the liquidity available in the overall economy.

But the end result was that interest rates shot up to as high as 20% and the US fell into two back-to-back recessions. Unemployment rates went up to 10% (as shown above) and stock market and real-estate values plummeted. And yet… Inflation fell from 20% to 3.2% within three years. So that’s a good thing… Right?

Volcker’s methods were controversial and they were both praised and criticized. While inflation was brought under control, others thought that the recessions that followed affected the poor disproportionately. Yet it’s not clear if there was any other option - it seems inevitable. To back up this argument, one measure of the population's pain is “the Misery Index” which simply adds up the inflation and unemployment rates.

Misery Index | Source: FRED Economic Data

While unemployment did shoot up after Volcker raised rates, the misery index fell rapidly from 21% to 12.5% and was close to 9% by the time he left the Federal Reserve in 1987. Though the unemployment rate increased short term, the economy stabilized in a few years. With all that said, the situation now seems eerily similar. The misery index is rising after dropping to an all-time low of 5% in 2015. So…

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What are we in for?

It’s accepted that the Federal Reserve is going to be raising rates. The only question is whether we are in for a hard landing or a soft landing. A soft landing is a phase where there’s a gradual slowdown in economic activity after a period of rapid growth. In a perfect world, the Fed can slowly increase rates and gradually decrease inflation, and everything will be alright.

But the Fed doesn’t have a great track record of doing this. Out of the 13 rate hike cycles before, 10 have preceded a recession, and as Fannie May has concluded, we are much more likely to see “a hard landing,” as the Fed signals that they’re about to be much more aggressive than they have been. The goal is to achieve a neutral rate of somewhere between 2.2 to 2.75% (but a neutral rate can only be estimated. We wouldn’t know if we are right until later). If inflation doesn’t come down even then, we might see rates climbing up to 4.25%.

So here’s what might happen.

1. Savings accounts might start paying interest. It’s been a long time since banks paid any interest on savings accounts (even so-called high-interest ones), to incentivize people to spend or invest their money. But that might change with the Fed raising rates. Don’t expect a 3% interest anytime soon, but your savings accounts just might start paying you some money.

2. Stock markets should probably go down… Except they haven’t in the past. The stock market has defied all odds since the 1960s and continued to plod upwards regardless of whether rates were slashed or raised. In fact, the most likely outcome in the month after rate hikes is a 5% increase! While growth and tech stocks go down when rate hikes are slashed, industries like semiconductors and banking actually rise in tandem with the rates and improving economy.

   

   S&P500 vs rate hikes

3. And finally, we have home prices. With mortgage rates climbing for 7 weeks straight, there are worries that home sales will fall. But it’s not so simple. There are other factors at play - If somebody locks in a home at a historical low, they would be reluctant to sell it or trade-up when mortgage rates are high. This reduces inventory, and prices depend on other conditions like demand, population changes, and tax deductions. So rising rates alone won’t damage real estate, but real estate values might decline due to lesser affordability in the long term.

Higher rate hikes also come with other side effects like higher credit card rates and auto loan rates, and it just makes borrowing difficult in general. So what can we do about it?

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Conclusion

According to the White House, the inflation we’re seeing is most similar to what happened right after World War 2. The episode back then was due to pent-up demand and disrupted supply chains, and it normalized after a couple of years. For all we know, a Volcker shock might not even happen if the Fed manages a smooth landing. But they do have a track record of…umm.. hard landings and sending the market on a rollercoaster ride.

But having said that, the best thing you can do is to stay employable and make yourself indispensable as possible. It’s a good idea to keep a 3-6 month emergency fund at all times and only take on fixed-rate debts if you’re buying a house or a car. Also, only make investments that you plan to keep for at least 7-10 years. Yes - these are the same things I’d be telling you to do when times are good, and you should always practice strong financial habits regardless of the situation.

As for me, I’m not changing my plan. Even if the Federal Reserve Volcker shocks the market and rug pulls us with higher rates, I’m just going to keep piling into the market daily and stay prepared. See you next week with another deep dive!

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