Deja Vu for Fed?

After 27 months and 17 consecutive rate hikes, the Fed finally decided to sit on the sidelines Tuesday. The move was widely expected, and that probably explains why both the stock and bond markets sold off.

In its statement, the FOMC mentioned that economic growth had moderated from the strong pace of earlier in year, but some inflation risks remained. It added that any additional firming would depend on "the evolution of both inflation and growth, as implied by incoming information."

If history is any guide, the Fed's pause will be just that -- a pause -- with a few more hikes to come before all is really said and done. Those last few may end up to be the final nails in the economy's coffin, unfortunately.

The years of malaise
I'm not going to bash the Fed as so many people love to do. But I will say this: It's too bad that the only policy response to inflation (perceived or real) is to take down the economy and drive up unemployment, because that's exactly what is happening and what willcontinue to happen under this policy response.

As it stands right now, the 17 rate hikes that have occurred since June 2004 is a record, beating out the 14 increases that took place from August 1977 to February 1980. In that campaign, the discount rate (prior tool used by Fed) went from 5.25% to 13%. Then the Fed paused for a while, only to resume again in September of that year. By May 1981, when the final rate hike was put through, the official discount rate stood at 17% and Fed funds topped out at just shy of 20%!

It's instructive to note that the Fed resumed hiking rates in 1981 despite the fact that it was already evident in early 1979 that growth was decelerating rapidly. The nation's GDP had gone from a 4% annualized growth pace in mid-1978 to zero by the first quarter of 1979. By April 1980, output actually contracted by 2%, constituting a six-percentage-point negative swing from peak to trough. To put it in perspective, it would be like today's economy taking an $800 billion hit.

As soon as the Fed stopped hiking rates in 1980, things began to improve. Like a prizefighter lifting himself off the canvas after a near-knockout, the economy clawed its way back. But then the Fed went in for the kill and bludgeoned it with those final series of increases, sending it down for the count. By 1982, the country was in a deep recession and unemployment soared to 11%! The question is: Why did the Fed continue to hike so aggressively when economic growth was already contracting sharply? The answer is because it was focused on inflation, not growth.

Therein lies the problem.

When all you have is a hammer.
Inflation, unfortunately, is a moving target, and that makes it almost impossible to hit. The inflation number you see now only tells you what has happened up until now; it doesn't tell you what the inflation rate will be next month -- let alone six months or a year from now.

Further complicating the matter is the fact that because there's a time lag between the implementation of monetary policy and its effect on the economy (and inflation), there's almost a 100% certainty that the Fed will end up going too far.

Witness the proof: Even though economic activity plunged between mid-1978 and April 1980, the core CPI continued to rise, hitting a 13.6% annualized rate by June 1980. But that was the peak, even if the Fed didn't know it at the time. To the Fed, inflation looked like it was going to continue rising, but in actuality, it was like a spent rocket, rising solely on momentum that was also about to fade. Therefore, the additional rate hikes were a fairly blunt instrument for combating the problem, but unfortunately for many folks who lost their jobs, that only became obvious when it was too late.

Stagflation ahead?
Many people are comparing the current period with the late 1970s, saying that the Fed will have to keep on raising rates in order to battle inflation, even should the economy slow. Some are even going as far as to say that we're experiencing the return of stagflation. I think that view may be a bit extreme. Many things have changed since the 1970s, and all of them suggest that stagflation is not on the horizon. Furthermore, the Fed is aware of this and will likely do all it can to avoid bludgeoning the economy.

Some of the changes I alluded to include new advances in technology, which have enabled greater business productivity. Computers, high-speed communications, and robotics, as well as numerous other technological developments, help companies stay profitable and competitive by reducing costs.

Then there's the global economy, which for all intents and purposes didn't exist three decades ago -- at least not in the sense that we know it today. The global economy allows American firms to outsource cheap labor from places like China, Taiwan, Korea, Thailand, Indonesia, Brazil, and Mexico. In fact, the pool of cheap labor is so vast that it constantly emanates deflationary pressure.

Globalization has also produced another benefit. Rising wealth in the developing world has also led to a surfeit of savings. Remember the "global savings glut" that Fed Chairman Ben Bernanke spoke about? Much of those savings have found their way back to the U.S., thereby keeping interest rates and the cost of capital low.

As for the economy in general, it has undergone a huge transition from what it once was: a heavy industrial based manufacturing-oriented system. Now we're much more of a service-oriented, light industry, information-processing, and finance economy. This lighter, "information age" economy produces higher output and tends to generate lower rates of inflation and consume less capital, resources, and labor. It's one of the reasons why the high price of oil now has less of an effect on the economy than it did in the past.

It's true. Even though we consume more oil and despite the fact that prices are at a record high, the cost of that oil today represents a smaller percentage of GDP than it did 25 years ago. In fact, even if the price of crude oil rose to $90 per barrel, it would still only represent about the same percentage of GDP as it did in 1980, when crude was about $22 per barrel.

So the bottom line is that I'm optimistic. And while I do think that the Fed will, unfortunately, follow past Fed mistakes by resuming the rate hikes for a short time longer, most of its work has already been done. For financial markets -- meaning stocks and bonds -- this will be good news. And one more thing -- if, over the course of the next few days or weeks, the markets respond negatively to this, you may want to be a contrarian and use that as a buying opportunity.

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Mike Norman is founder and publisher of theEconomic Contrarian Update, as well asa Fox News business contributor. He is also a radio show host at BizRadio Network.


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