Swith inflation is a former Federal Reserve Chairman in the minds of politicians and pundits alike. Some have argued that Jerome Powell, the current incumbent, must not become the next Arthur Burns. As Chairman of the Fed in the 1970s, Burns epitomized central bank failure: a weak leader who blinked in the face of inflation and steered the economy towards disaster.
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It’s not that this warning from history is wrong. Richard Nixon chose Burns to run the Fed, seeing him as a friend who would do his will. In 1971, despite persistent inflation, Nixon urged Burns to lower interest rates, thinking it would help him win re-election. Sure enough, the Fed did just that. Nixon was re-elected and inflation skyrocketed, reaching double digits by 1974.
But the story is more complicated than its outline suggests, and its complexity holds lessons for today’s policymakers. With the holiday season upon us – and as the Fed nears a turning point in monetary policy – it’s a good time to reassess the legacy of the much-maligned central banker.
Start with what happened after inflation set in. The Fed hiked interest rates from 3% in 1972 to 13% in 1974, one of the sharpest tightenings ever and enough to plunge the economy into a deep recession. This slowed price growth somewhat, and inflation settled at around 6% for the remainder of Burns’ tenure. That was uncomfortably high, and Burns never dealt the deathblow to inflation that Paul Volcker dealt in the early 1980s. Nevertheless, his first attack heralded a new era. In 2016, economists at the Richmond Branch of the Fed assessed monetary policy conditions over the years. Their model indicated that the “Volcker shock” did not appear like a bolt from the blue. Burns had laid the foundation for it.
He did this under terrible circumstances. An oil shock that began in 1973 nearly quadrupled energy prices and increased food costs. A second oil shock in 1978, shortly after Burns left the Fed, triggered another surge in inflation. Against this backdrop, how much of the inflation can really be blamed on the Fed? A 2008 review by economists Alan Blinder and Jeremy Rudd found that supply-side factors were key. They calculated that the energy and food crises accounted for more than 100% of the rise in headline inflation compared to its baseline. The Fed could have reacted more strongly as inflation was already unanchored. But Burns wasn’t responsible for the massive economic shocks.
Burns’ problems also illustrate the pitfalls of real-time indicators. The Fed is considered “data dependent” today. If inflation dynamics remain relatively weak, the next rate hike is likely to be a quarter of a point; If inflation starts to spike again, a half-point hike could be on the menu. That is perfectly reasonable. But consider the 1975 head forger. Initial Q1 data showed a 10% annualized decline bip and an easing of price pressure. The Fed cut rates aggressively. Subsequent revisions showed that the bip Loss was only about 5% and inflation remained stubborn. Had this been known at the time, the Burns Fed might have acted differently.
That real-time numbers can be in error doesn’t help much on one level: it’s impossible to know whether future revisions will push growth up or down. However, this uncertainty discourages overreacting to limited data. After tightening monetary policy so much over the past year, the Fed wants to take a more cautious approach. Even if inflation surprises on the upside ahead of its next meeting in February, sticking with this gradual approach might still be the way to go – just as Mr Powell avoided reading too much into an apparent inflation slowdown in November.
Of course, the key economic outcome associated with Burns’ Fed is high inflation. However, his relatively loose policies also fueled an investment boom. Capital expenditures — that is, money companies spend on things like buildings and equipment — reached about a third of the US dollar bip in 1978, which is still the highest level since at least 1946. Much of it went into energy and commodity production in response to the supply shocks at the time. Jeffrey Currie of Goldman Sachs, a bank, recently noted that these investments helped “eliminate” decades of oil and metals production capacity and long-term prepared the economy for lower inflation.
Today, the global economy is at another turning point. The frayed global trading system, declining immigration and climate change may well constrain America’s productivity, resulting in persistently slower growth and higher inflation. There is also renewed debate among economists as to whether the Fed should aim for a slightly higher inflation target than 2%. Such a move could help avoid putting too much pressure on the economy in the face of profound challenges. The Fed’s job is to accurately predict the future shape of the economy and how it will interact with monetary policy. The profound impact of the investment boom of the 1970s is a reminder that he must be mindful of the current series of economic structural shifts.
First degree burns
The more closely you examine Burns’ file, the more complex it becomes. The former Fed chairman carefully oversaw the resolution of a major bank in 1974, heralding the central bank’s current framework to let bad firms fail unless it leads to a financial crisis. His advocacy for wage controls is now considered a classic example of bad policy doomed to fail. The context, however, was a powerful labor movement that had imposed upward cost-of-living adjustments – something that no longer exists. His relationship with Nixon is also anything but straightforward. Burns was no toady and at least tried to resist the president’s bullying. All of this provides the final and most important lesson from the Fed’s great anti-hero: Historical analogies are useful, but rarely the full story. ■
Read more from Free Exchange, our column on business:
The Insidious Threats to Central Bank Independence (15th December)
Tackling sexual harassment could bring significant economic benefits (December 8)
A 1980s playbook for dealing with inflation (December 1)
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