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The following is a quote from Allan Meltzer’s A History of the Federal Reserve, covering the Fed’s miserable experiences in the 1970s. It was pointed out to me by Chris Watling of Longview Economics in London:

The FOMC made several errors and had some bad luck. The oil price increase was non-monetary and did not require a monetary response. Error or misinterpretation caused them to treat the (subsequent) decline in output as a recession instead of a ‘permanent loss of wealth’ and output, in effect a response to a tax paid to foreign oil producers that transferred wealth. Ignoring the difference between the temporary and persistent rate of price change or responding to the loss of output (with stimulus) contributed to inflation. Countries that did not make this error, notably Germany and Switzerland, had much lower inflation rates. The different inflationary responses suggest that policy responses to the decline in output following the increase in the relative price of oil was an important determinant of the size of subsequent inflation.

The West German Bundesbank did a much better job of controlling inflation in the 1970s than the Fed (and Pill worked for many years at its successor, the European Central Bank). West Germany and Switzerland also at that point had much more cohesive societies that were easier to persuade than most western countries to share the pain than would be the case now.

The main lesson for today might be that central banks should not have been anything like as generous in 2020 and 2021. It also, according to Watling, suggests that the risk now is from the current attempts to reduce the money supply. He said:

If the effect of ‘too much money creation’ in the pandemic led to too much inflation (boosted by supply side shocks) and growth, then the corollary is that ‘too little money creation’ (or indeed money destruction) should lead to not enough inflation (i.e. deflation) and negative growth. That has certainly been the history of large spikes in money creation and subsequent phases of contraction. Indeed under the gold standard, designed to keep prices stable over time (i.e. zero average inflation), bouts of inflation were typically followed by periods of deflation (and negative money growth).

If he’s correct that central bankers, including the BOE, are now overtightening, Watling suggests that profit margins should soon come under pressure as companies have to cope with falling prices in many areas of the economy. At present, they’re using rising prices to expand operating margins, inflation should turn to deflation, and bonds should outperform equities significantly (as one rallies, and the other declines). 

Earnings Season

Evidence in support of Watling’s line is appearing day by day in earnings announcements.

Photographer: Klaus Rose/Ullstein Bild/Getty



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