RateWatch #411 – Presidents and the Economy

June 12, 2004 by Dick Lepre

What's Happening

This past week's Treasury auction was well received. On Thursday, additional Fed members continued to talk the hard line: large Fed funds increases if inflation exceeds forecast. What is foremost in folks' minds is the situation in 1994 when the Fed, in hindsight, raised rates too slowly. Current consensus is that the Fed will hike 0.25 at the June 30 meeting and another 0.25% on August 10. CPI above expectations could accelerate the speed of the increases and turn
one of those hikes into 0.5%. What is most important to keep in mind is that so much of this is about perception. The Fed's actions are effective only if they change perceptions with the effect of containing inflation.

Presidents and the Economy

About 10 days ago I started to write a newsletter about the effect that Presidents have on the economy. President Reagan's death has created a large amount of discussion about the effects
of the actions of Presidents.

What I was originally intending to say was that the constant blather that we hear on TV and radio, and read in print about the responsibility that the President has for the state of the economy
greatly exaggerates the role.

I think that Reagan was an exception not because of his policies but because of his attitude and the timing of that attitude. The U.S. economy had been seriously hurt as a result of the Arab Oil
Boycott of 1973 and during the tenures of Presidents Ford and Carter the situation seemed insurmountable. We had high inflation and high unemployment.  The Iran hostage thing during the Carter administration made America feel lousy.  Onto the scene comes Ronald Reagan.  This was a strange man by Washington standards. He had been an actor and a TV spokesman for GE but had been governor of California and, thus, had some credibility as a leader. His unabashedly positive attitude about America, its values and its importance as a world leader was infectious.  It rubbed off on the average American.  The willingness of America to feel good again ended a period of malaise that included: depression about the assassination of JFK, Vietnam, Watergate, stagflation and the Iran hostage crisis.

To get back to the point that I originally intended, I think that the way that the economy works now, the Chairman of the Federal Reserve is much more important than the President.  To credit
Bush for recent jobs gains makes no more sense than blaming his for the job losses.  For the first years of the Clinton's second term the economy did spectacularly.  In the last two years of his tenure economic growth turned down.  I do not think that he deserves much credit or much blame. 

The current run of success that the Federal Reserve is on began with Paul Volker.  In 1979 the country was in a funk. Interest rates were high and inflation was high.  In January of 1979 the Shah
of Iran fled the country because the populace, basically, wanted to lynch him.  In October of 1979 he came to the U.S. for cancer treatment in New York. Ayatollah Khomeini who had returned
to run Iran took offense at our willingness to prolong the life of the Shah (they really didn't like this guy) and the taking of hostages at the U.S. embassy ensued. On the news every evening starting in November were pictures of staged demonstrations in Tehran of the folks who held the American hostages telling us that our country sucked.  The Treasury Secretary was Michael Blumenthal and the Chairman of the Federal reserve was G. William Miller.  The Fed Chairman thought that inflation would stop of its own accord.  The Treasury Secretary thought that higher rates were necessary to control inflation.  This disagreement became very public.  Blumenthal and Miller were canned and Paul Volker was nominated to be the head of the Fed.

When Volker came onto the scene we had "stagflation" - inflation coupled with no or weak GDP growth.  In October 1979 PPI was +17%.  Unemployment was a low 5.8%.  Volker made it very clear in public that that he was declaring war on inflation.  The discount rate was raised to 12%.  This was a war that was not quickly won. One effect of Volker's actions was that Carter was not reelected. But Volker was not playing politics. He continued to tweak the Fed funds rate until it hit 20% in June 1981.  The desired effect of containing inflation was achieved only with a prolonged recession.  The recession lasted from July 1981 until November 1982.  Unemployment was 9.7%. In fact, the economy, at that point was like a patient in post-op.  It felt awful but the surgery had been successful. In 1982 CPI was +3.8%.  Inflation had been killed.  The patient lived. Volker loosened the money supply in mid-1982 and things did quite well.

Volker was Fed Chairman until June 1987 when a guy named Greenspan took over.  Since 1980 the Fed has shown who really controls the economy.  At present, the Fed is at another turning point.  The trick is to get interest rates off these record low levels with the goals of preserving GDP growth and preventing inflation.  The analogy is to a race car entering and leaving a turn.  Increasing rates too slowly could allow inflation.  Increasing rates too quickly could hurt GDP.  Business cycles still exist and the Fed must try to find the "sweet spot" for the Fed funds rate.

Discussions about the achievements of Reagan or Clinton have value - they take up time and sell advertising on cable TV. Fortunately, Greenspan is becoming a character with high visibility
and the media is starting to recognize that the Fed's control over monetary policy may indeed be more important than whatever the President and Congress do. 

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