What if Jerome Powell wins the inflation fight?
In the wake of the Federal Reserve’s big rate hike this week, some commentators are comparing the Fed chairman with one of his predecessors: Paul Volcker. The Fed’s leader under Jimmy Carter and Ronald Reagan introduced aggressive monetary tightening in the early 1980s, which thrust the U.S. into a recession but rammed inflation down to consistently low levels. That led to a decades-long period of prosperity known as the “Great Moderation.” Can the increasingly hawkish Powell have similar success?
Before we address that, let’s note that it’s a critical question for bitcoin, whose advocates position it as “sound money,” a more reliable system for protecting purchasing power that’s immune to the human failings of fiat-based monetary policy.
Whether Bitcoin succeeds will largely hinge on whether people have confidence in the incumbent fiat system to which it poses an alternative and in the central bankers who, since the end of the dollar’s gold peg 1973, have determined the monetary policies behind that system. If people lose faith in central banks, the idea goes, currencies will falter, exacerbating inflationary pressures and driving users to alternatives like gold or bitcoin.
So, in the minds of bitcoiners, this a major test moment for Powell.
To be fair, in light of cratered crypto markets, bitcoin is also being put to a major test right now. But it’s Powell we’re focused on here. Can he do another Volcker?
Myth, message and reality
In the 1980s, Volcker almost single-handedly restored trust in the global fiat system. Taking a politically difficult stand that reinforced the economy’s long-term health earned him quasi-sainthood in financial circles – the antithesis of his predecessor, the hapless Arthur F. Burns. Volcker also demonstrated to governments and their voters the value of central bank independence.
Among economists, conventional wisdom now holds that if a country’s political leaders ignore Volcker’s legacy and stop central banks from making tough decisions, markets will punish them. Currency failures such as Zimbabwe’s, Argentina’s and Turkey’s are pointed to as examples. By contrast, the U.S. economy’s long, mostly steady and rarely interrupted expansion since Volcker’s 1982 recession, and the concurrent 40-year growth in its stock market – with a more than 100-fold increase in the S&P 500 to its peak last year – is presented as proof of the payoff to those who play by the rules.
The reality is much more complicated.
As we discussed two weeks ago, the dollar’s status as the dominant reserve currency gives the U.S. unique latitude with monetary policy and creates fallout in other countries.
In the years following the 2008 financial crisis, the Fed’s highly accommodative monetary policy pushed “hot money” into developing economies, making policymaking doubly difficult there. Now that the dollar is resurging, hot money is fleeing back to the U.S., forcing central banks everywhere to follow the Fed’s monetary tightening lead to protect their currencies, whether their economies warrant that or not. Volckerism isn’t exercised on a level playing field.
Political risks vs reputational risks
These global imbalances and the “quantitative easing” (QE) monetary policies they permitted have reached a breaking point. They fueled a massive debt buildup in the U.S. and elsewhere, which will become much harder to reckon with now that interest rates are rising.
The policy reversal will prompt a flood of bankruptcies and an economic contraction, and there’s no guarantee it will tame inflation. That could remain propped up by war-fueled commodity price gains, supply chain inefficiencies and entrenched, self-fulfilling expectations. What will Powell’s Fed do in that environment? Will it push even harder, driving the U.S. economy into a much deeper hole?
My bet is “no.” There is too much at risk politically. The pressure to soften monetary conditions again will be too strong once U.S. businesses are shuttering en masse and hordes of Americans are losing jobs. And when that happens, as low-cost money is again pushed out into the world in search of risky assets, bitcoin will benefit as one target of those flows.
But the bigger, longer-term issue is not whether the Fed could be pulled into this whipsaw response, but what Powell’s bold new stance will do to his and other central bankers’ reputation over time.
If he succeeds in cooling speculative excesses and ushers in another era of predictable, moderate inflation, Powell could give the entire fiat system and its dollar-based center a shot in the arm for years to come. It will make it hard for bitcoin – or gold, for that matter – to make an alternative case.
A lot is resting on this. It’s not enough for bitcoiners to say the dollar has steadily lost purchasing power because of inflation. What most people want is predictability. Far from worrying about a 2% annual inflation rate depleting the value of their dollars, investors were comfortable with that consistency during the Great Moderation. A return to similar stability would be a huge win for fiat.
This is not 1982
What does success mean, though? Ultimately, it comes down to our perception of the outcome. The problem is Powell is trying to explain his strategies in a far more hostile environment than Volcker faced.
In 1982, the U.S. had the wind at its back. The computing revolution was just starting, which put the country on the cusp of a productivity boom, while the more disruptive aspects of the internet age were still in the distant future. The U.S. was on the verge of winning the Cold War and had mostly gotten over the social tensions of the Vietnam War. Most important, the wealth gap was nowhere near as extreme as it is now. Americans were optimistic.
Fast forward to 2022. There’s a war in Ukraine, which led to Russia’s (and potentially China’s) exit from the dollar-centric global financial system. The planet faces a climate disaster and an entire generation of teenagers and twentysomethings is emerging from a global pandemic with an abiding cynicism toward an ossified 20-century capitalist order.
Meanwhile, it has become so much harder for the Fed, or any policymaker, to control the message. I’m not talking about their communication channels with bond traders, which they use to signal market rate adjustments; I’m talking about communicating with us, we the public.
At the end of the day, what matters for a central bank charged with protecting a currency’s value is the judgment of the currency’s everyday users. These days, those people’s views are shaped by social media, a sprawling, unpredictable system captured by bots and trolls. This makes it very difficult for policymakers to manage their message and sustain trust.
Success is far, far from guaranteed for Powell. That means that bitcoin, for now, remains relevant.