About the author: Joseph H. Davis is global chief economist and global head of the Investment Strategy Group at Vanguard.
In 1967, the U.S. economy experienced the most softish of landings. Growth that had been around 6% the three previous years slowed to 2.7% as demand for goods and services continued to outstrip supply, a development enabled by expansive fiscal policy and acceleration of the Vietnam War. The yield curve had inverted a year earlier, but recession didn’t follow. Notably, and at least partly in response to a banking credit crunch (sound familiar?) in late 1966, the Federal Reserve cut interest rates, even though inflation had recently pushed through a 2% ceiling that had held for more than a decade. The Standard & Poor’s 500 Index climbed by 20%.
Some economists point to 1967 as a guidepost for a similar outcome in 2023. But that 1967 outcome was in fact a pyrrhic victory, a brief pause leading up to a hard landing. Within a year, the economy was overheating again. By 1969, inflation had surged above 6%; the federal funds rate target, at 9%, was double its 1967 level; and recession set in late in the year. Though few realized it then, 1967 had been a launchpad for the Great Inflation, the 1965-1982 period of surging prices that required an 18% federal funds rate target to eventually quell. So much for soft landings.
We’re not on the cusp of another Great Inflation. The Federal Reserve has aggressively tightened monetary policy, not loosened it. But important parallels between 1967 and today offer some lessons for policy makers and the markets.
Lesson No. 1: Raise rates well above the current inflation rate and hold them there. The Fed’s premature pivot to cutting rates in the summer of 1967 given a growth slowdown was unfortunate. Inflation never declined from its sticky 3% rate during 1967. The lowering of interest rates in the face of a tight labor market opened the door to broader inflation and wage pressures within months. The history of disinflationary periods is clear: Rates need to exceed the current rate of inflation for at least a year to pull the trend line down. Given that the Fed’s effective federal funds rate does not yet exceed certain inflation rates, the summer of 1967 should remind the bond market that entertaining a pivot in 2023 would be ill-advised.
Lesson No. 2: Minimize reliance on the unobservable. An unfortunate parallel between the late 1960s and today is a reliance on abstract measures that can underestimate the level of monetary policy that promotes a balanced economy. For the Fed of 1967 it was NAIRU, the nonaccelerating inflation rate of unemployment, which suggested then that unemployment rates below 4% didn’t necessarily rule out rate cuts. With the benefit of hindsight, we now know that NAIRU back then exceeded 6%. For today’s Fed it is the neutral rate, the unobserved rate at which monetary policy would be considered to neither stimulate nor restrict an economy. Vanguard’s internal analysis suggests that the Fed’s assumption of a 2.5% neutral rate is about a percentage point too low, and that more concrete measures signal the need for higher policy rates.
Lesson No. 3: Labor-market balance holds the key. Rather than place too much emphasis on unobserved concepts such as the neutral rate or NAIRU, which are prone to significant mismeasurement, policymakers and investors can consult simple, real-time measures that demonstrate the balance between labor supply and demand. One such measure is peerless for its simplicity and its predictive power: the ratio of job openings to the number of unemployed. For an economy in balance, the ratio should be 1:1. At the start of 2023, the ratio was nearly 2:1, a level last seen in—you guessed it—the late 1960s, and a scenario sure to sustain sticky wage inflation. In 1967, that 2:1 ratio dipped only a bit before turning right back up. Such tightness was evident in newspaper want ads. Other indicators today similarly reveal a tight labor market.
Supply shocks related to Covid-19 and the war in Ukraine no doubt have contributed to high inflation, just as two energy shocks in the 1970s exacerbated the challenges of the Great Inflation. But increased demand related to Covid-era labor market dynamics and expansionary fiscal policy has played its part in raising both inflation and the level of short rates needed to bring inflation back down. The ratio of job openings to the unemployed, now at 1.6:1, clearly needs to fall further to bring inflation in line. There is little chance of escaping that tradeoff if we wish to avoid a pyrrhic victory as in 1967.
The job of a central banker is one of the most difficult in the world. The margin for error is slim and the effects of getting it wrong can be far-reaching. Our humble recommendation for the Fed is like our guidance for everyday investors: Heed history, respect the future. Stay the course of monetary policy restrictive enough to ensure that inflation, once tamed, doesn’t roar back to life.
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