Mark J. Higgins, CFA, CFP, and Raphael Palone, CFA, CFP, will present at Planejar Annual Conference in Sao Paulo, Brazil, October 24, 2022. Their program compares the U.S. Federal Reserve’s response to post-COVID-19 inflation with its policies after the Great Flu and World War I in 1919 and 1920.
“I think the main obstacles (to international coordination of monetary policy) are that it sounds good in theory, but when the exchange rate target seems to conflict with the domestic emergency, the domestic emergency the It is politically very difficult to appear to subordinate domestic policy to the stability of international exchange rates, although in the long run it may be a desirable thing to do. Paul Volcker
Aggressive monetary tightening by the US Federal Reserve is on a scale the world has not seen since the early 1980s. Over the past year, US stock markets have suffered substantial losses, but the the US economy and financial system remain on a reasonably solid footing. The situation abroad is more precarious. Higher US interest rates and a strong dollar are disrupting cross-border capital flows and straining the finances of countries holding large amounts of dollar-denominated debt.
Another feature of the COVID-19 pandemic that has caught investors off guard is the impact of Fed policy on the global financial system. But much like post-pandemic inflation, it is hardly unprecedented. Since the end of World War I, US monetary policy has shaped cross-border capital flows, central bank policies, and debt service sustainability around the world. It’s a power the United States assumed when it became the world’s largest creditor after World War I and the world’s largest issuer of reserve currency after World War II.
The Fed’s policies will undoubtedly shake the world again in the coming months. In fact, the United Nations Conference on Trade and Development released a disturbing report earlier this month warning of potentially serious ramifications in some of the most vulnerable countries. Beyond these generalities, however, it is difficult to predict how Fed policy will unfold across the globe. But one question merits consideration: will the Fed adjust its policies in the interests of global financial stability?
Two scenarios from history can help answer this question.
Ben Strong and the Roaring 20s
The Fed tightened monetary policy aggressively in 1920 for a familiar reason: to control inflation. This led to a sharp but relatively short depression. The economy recovered in 1922 only to start overheating in the mid-1920s. This put the Fed in a difficult position. Blamed in part for causing the depression of 1920–21, Fed leaders feared repeating their mistake and were biased against a premature rate hike. To complicate matters further, the Fed has come under intense pressure from European central bankers to keep rates low. For what? Because if the Fed raised rates, gold would flow from Europe to the United States as investors seek higher returns on capital. This would threaten post-war reconstruction by reducing the European money supply and forcing European central banks to raise interest rates to stem the outflow of gold.
The Fed’s commitment to European reconstruction was first tested by the United Kingdom in 1925. After World War I, the pound had largely lost its reserve currency status to the US dollar. . But the political leaders of the United Kingdom wanted to restore it. Amid calls from the leaders of the Bank of England and its Conservative Party to restore the gold standard, Winston Churchill as Chancellor of the Exchequer bowed to pressure. The pound, he announced, would return to the fixed pre-war exchange rate of $4.86.. This significantly overvalued the pound, instantly rendering British exports uncompetitive. This increased gold shipments from the UK to the US and created problems for both countries: the UK suffered a painful recession, while the US money supply expanded rapidly and undesirably. .
In the spring of 1927, fearing that the Fed might raise interest rates again amid rising inflation and speculation, central bankers from the United Kingdom, Germany, and France traveled to the United States to push for an accommodative monetary policy. New York Federal Reserve Governor Ben Strong helped convince fellow Fed leaders to accede to European demands. But they went further: instead of keeping rates stable, they reduced them. The Federal Reserve Bank of New York cut the rediscount rate from 4.0% to 3.5%. The cut was approved with only one dissenter, Adolph C. Miller, whose words proved prescient. He described the decision as “The largest and boldest operation ever undertaken by the Federal Reserve System, and . . . one of the costliest mistakes made by it or any other banking system in the last 75 years!”
It was not an exaggeration. The Fed’s overly accommodative monetary policy fueled rampant speculation in the late 1920s. This culminated in the catastrophic crash of October 1929, which sparked the Great Depression. The Depression, in turn, created the difficult economic conditions that allowed the rise of the Nazi Party and Japanese militarists.
Paul Volcker and the Great Inflation
Fed Chairman Paul Volcker announced his famous monetary tightening program on October 6, 1979. Volcker understood that this would have enormous consequences outside the United States. But he did not let this affect his political decisions. His priority was first to bring US inflation under control and then to deal with the consequences, both foreign and domestic, as they emerged.
Volcker’s monetary tightening persisted for nearly two years. As inflation slowed and the U.S. economy could no longer sustain austerity, the Fed began easing rates in July 1981. The United States slowly emerged from the severe recession of 1981–82, and the price stability that followed helped fuel nearly two decades of prosperity.
Other nations did not fare as well. The situation in Latin America was particularly painful. Indeed, the 1980s are often considered Latin America’s lost decade. The sharp and sudden rise in interest rates in the United States led to a substantial appreciation of the dollar against many foreign currencies. Many Latin American countries had incurred debt denominated in US dollars, often at floating rates, throughout the 1970s. Now they faced higher interest payments in dollars as their own currencies plunged value. Mexico was particularly hard hit, defaulting on its foreign debt in August 1982.
Although the Fed has provided significant aid to Mexico, among other countries, international pain has not deterred Volcker from taking its course. The domestic concerns of the United States clearly took priority. This element of Volcker’s philosophy is what most distinguishes him from Strong.
What does this mean outside of the United States?
The extent to which the Fed will adjust and recalibrate its policies based on their global impact is unclear. But we expect the Fed to follow Volcker’s model more than Strong’s. The current political atmosphere in the United States is focused on domestic concerns. All other things being equal, the Fed will likely reflect the views of the American people.
So when it comes to US monetary policy, foreign governments would do well to brace for a lot of Volcker and hope a little Strong.
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All posts are the opinion of the author. As such, they should not be construed as investment advice, and the opinions expressed do not necessarily reflect the views of the CFA Institute or the author’s employer.
Photo credit: ©Getty Images/Douglas Rissing
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