There remains a lot of anxiety over whether inflation in the US will gather steam all over again. Part of this worry stems from the fact that there were multiple bouts of inflation in the 1970s, which was the last time the US had a serious inflation problem. So to understand whether our current environment bears similar risks to that of the 70s, it's important to understand what actually drove inflation during that period. On this episode, we speak with Itamar Drechsler, a finance professor at Penn's Wharton school. He argues that the banking regulation known as Reg Q impaired the transmission of monetary policy, and resulted in a perverse dynamic via which rate hikes served to impair the supply side of the economy, rather than cool the demand side. This transcript has been lightly edited for clarity.
Key insights from the pod:
Standard interpretations of 1970s inflation — 4:57
The role of Reg Q limits on bank deposits — 6:53
What got Itamar interested in this research — 10:00
Monetarism in the 1970s — 13:02
The link between bank deposits and prices — 15:28
What the data says — 17:20
The link between bank deposits and demand— 18:50
The 1970s wedge in rates — 20:15
The link between bank deposits and supply — 23:18
Why aren’t bank deposit rates rising more now — 30:38
Bank disintermediation and inflation now — 32:52
Reg Q, Ben Bernanke and housing credit — 36:14
Why didn’t policymakers just lift the deposit cap? — 37:40
What does this interpretation mean for inflation now? — 41:3
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Joe (00:00):
Hello and welcome to another episode of the Odd Lots podcast. I'm Joe Weisenthal.
Tracy (00:16):
And I’m Tracy Alloway.
Joe (00:18):
Tracy, you know, obviously we're recording this September 2023, inflation has come way down over the last year, but there is definitely anxiety about, well, could we see another wave, particularly if we don't have a recession? No one is really convinced that it's over.
Tracy (00:34):
So gas prices are starting to creep up again, house prices have been incredibly stable and [are] also starting to rise slightly, so that could also figure into shelter costs. But I think generally there is this concern that are we going to see another leg-up in inflation? And part of the reason there seems to be this concern is because, as we've discussed on this podcast before, everyone tends to reach for the 1970s as the big parallel or analogy for periods of higher inflation.
Joe (01:05):
When we were out in Jackson Hole, I guess in August, that was when Larry Summers tweeted that famous chart saying, you know, it's a good reminder.
Tracy (01:16):
This was when you were looking at the mountains and thinking of US CPI charts.
Joe (01:19):
The Grand Teton looked like the US CPI from 1974 to 1985, but it's true that throughout the seventies there were multiple times where people sort of breathed the sigh of relief. They said inflation has been licked and then it came [back]. There's this story that there's all this irresponsible policy, and then finally Volcker came and smashed inflation, and it really did not exactly happen like that.
Tracy (01:44):
I always find that kind of weird because Arthur Burns hiked rates a lot before Volcker did the same thing, but you're absolutely right and the inflation of the 1970s, it's important in many ways, possibly not the right ones, but one of the ways it's important is it tends to be the period that a lot of our policy makers and economists and academics kind of came of age in, and it tends to be the one that they go back to, to explain what's happening now.
And so, you know, there are some shades of the 1970s to our current situation. You did have supply shocks in the form of oil, there was, I think, some fiscal stimulus from the Vietnam War going into the 1970s, things like that. But overall, the sort of standard interpretation of the 1970s is that monetarist view, the old, like Milton Friedman ‘inflation is always and everywhere a monetary phenomenon’ and basically blaming the Fed for not reacting fast enough.
Joe (02:45):
You’re absolutely right and you mentioned that the 1970s looms so large, you know, policymakers, the Fed in particular, central bankers, they take a lot of pride in the fact that they defeated inflation, that inflation has been stable, that they sort of embedded this idea of stable inflation expectations. They prize that stability quite a bit. You and I, we joke a lot about how we both started our careers in 2008, right on the eve of the crisis.
Tracy (03:13):
So we're always worried about deflation!
Joe (03:15):
We’re always worried about, you know, crisis and downturn and surging unemployment and you look at the people who now make policy today, many of them, as you said, came of age then. But again, it feels as though if we're going to have a conversation about possible second waves, if we're going to compare and contrast now with the 1970s, then actually we better get a better handle on what really happened in the 1970s because I don't think that outside of these vague things, like ‘Oh, they let policy run too loose and some oil and gas lines,’ that actually we've really, you know, that there is a crisp, coherent story. Why was inflation so persistent and so reoccurring throughout, you know, roughly a decade?
Tracy (03:56):
The ghost of Paul Volcker is going to be so mad at us, but I think we should do this.
Joe (04:00):
Well, I'm very excited we have the perfect guest, someone who has done original research on 1970s inflation and really sort of broke down what happened. We are going to be speaking with Itamar Dreschler. He's a professor of finance at the University of Pennsylvania, someone who's done a lot of research on this period and what it means. Professor Dreschler, thank you so much for coming on Odd Lots.
Itamar Dreschler (04:21):
Thank you very much for having me. This is really fun and nice to talk about a topic I care a lot about and think is very interesting.
Joe (04:28):
Excellent. Well, you know what? Why don't we start with, if you were just in a room full of random economists and you said, ‘Well, what caused the 1970s inflation? Why did it keep coming back?’ What sort of, just like, you know, we mentioned in the beginning, you know, the gas lines and the end of the Vietnam War, and maybe policy makers were not strong enough in fighting it. But what is the sort of macro consensus about what happened in that decade?
Itamar (04:57):
So I think the most common story, narrative is that the Fed — there were at the outset, say, some kind of shocks that that led to the beginning of inflation, but that once inflation got going, the Fed did not respond aggressively enough to increases in inflation by raising the Fed funds rate as later policy would dictate, which is that according to the Taylor Rule, the Fed has to raise the nominal rate more than one-for-one with expected inflation.
What that does is raise the real interest rate there by lowering demand, or what they call demand management, and preventing inflation from accommodating inflation by letting it go up. So not doing that, they over time lost credibility and that meant that if people expected inflation to go up, inflation would actually go up because The Fed wasn't actually leaning into it, it wasn't making, it wasn't slowing demand in the face of, say, increasing inflation expectations. That, to the best that I understand, is kind of the most common narrative.
Tracy (05:57):
Right, so the idea is that prices started to rise. The Fed basically lost control of inflation expectations, and then you got this self-reinforcing cycle of the wage price spiral where people start demanding more money. Then it wasn't until Paul Volcker came in, told everyone who’s boss, reestablished the Fed's credibility and kind of deflated those inflation expectations that things got better.
So your paper takes a very different view to that whole narrative. You kind of place the blame squarely on an element of financial regulation that actually, Joe, I realize this has popped up a couple times on Odd Lots. Most notably in our episodes with Josh Younger and Lev Menand, where we were talking about the origins of eurodollars and shadow banks, but you place it on Reg Q. Can you talk a little bit more about that thesis?
Itamar (06:53):
So Reg Q does come up a lot, it's a very famous banking regulation. Historically people, many banking people and monetary people are well aware of it. Reg Q was a regulation that came out of the 1933 Banking Act that allowed the Fed to place a ceiling on what kind of interest rates banks could pay on different kinds of deposits.
And for example, checking deposits had to pay a zero-interest rate, savings deposits had their own ceiling and then CDs could have their own ceiling. For almost all of the time, from 1933 until 1965, the Fed put the ceiling above the Fed funds rate. So when it would raise the Fed funds rate, it would raise the ceiling and so basically it didn't bind, maybe it would prevent you from setting some crazy rate, but it didn't bind. But starting in ‘65, they didn't raise it. So that when they would raise the Fed funds rate, deposits couldn't keep up with the Fed funds rate.
Tracy (07:49):
So the reason they put in that restriction was because, my understanding is that in the 1930s, there were a lot of bank failures. And so there was concern that if banks were competing with each other to attract depositors, so just raising deposit rates to uneconomic levels, that it would lead to more bank failures. So they thought, ‘Well, we'll put a cap on this and then we'll have healthier competition.’ Is that right?
Itamar (08:15):
That’s the story that's told. It’s impossible to say that's exactly what was in their mind, but yes. Also that act established the FDIC and deposit insurance. So in some sense, it makes sense that if you're going to give people insurance, you don't want them to attract deposits by doing crazy things.
Joe (08:30):
Right, because if you know that you're insured, I could just go out and say, ‘Oh here's a 10% interest rate.’
Tracy (08:38):
The Bank of Joe and Tracy will offer 50% interest on deposits.
Joe (08:40):
I collect all of the deposits from everyone else, and maybe I fail because of whatever I'm doing with that, but I got all the deposits.
Itamar (08:47):
I mean, let's do it.
Tracy (08:50):
Okay, so I stopped you right up in the late 1960s. So in the late 1960s, they make this change.
Itamar (08:57):
Yeah, they debate it, but they decide to use this rule as a tool of monetary policy — very consciously. So this is part of a general wave of what was called credit controls that many developed countries used and had been exploring for a while. It was a popular idea that you could influence directly the price and quantity of credit in order to do monetary policy and not just leave it to the short-term rate.
And so this was used in the UK, famously in France and Italy and Belgium in the Netherlands, there was an awareness that credit controls of various types were used usually consisting of often together controls on the level of interest rates you could pay on deposit ceilings, on what you could charge for loans or ceilings on the quantity of loans you could make or loan growth.
Joe (09:46):
You know, it's interesting because — and I will get to the whole debunking of the popular story, or at least the reinterpretation of the popular story — I actually have two questions. From a professional standpoint, how did this become an area of interest in research for you?
Itamar (10:00):
It’s a little bit out of left field for me and my co-authors. I have two very common co-authors [and] we've worked a ton together at NYU, Alexi Savov and Philipp Schnabl, and we work on monetary policy and banking. We're coming at it from a finance point of view.
And the way we got to this was, so we think a lot about these things. We did not think so much about inflation. We're working on how the business of banking works and how banks’ ability to raise deposits is influenced by monetary policy, how much money they make on deposit spreads.
And we are presenting some of our work, and we noticed that if you just graph the Fed funds rate against deposit rates, the average deposit rate that banks pay, you can see very clearly that in the 1960s and seventies, the average deposit rate barely reacted at all to the Fed funds rate. Now, that's not a discovery because I knew about Regulation Q, and it had never been in my face that way. There's a very famous graph coming out of the literature of the standard narrative. Clarida Gali Gertler has the most famous paper with thousands of citations that has a similar graph, but instead of deposit rates, which they don't consider, they have the Fed funds rate in inflation.
That's the famous graph that shows that before 1982 the Fed funds rate just mostly kind of sticks to inflation. Whereas afterwards, with Volcker and Greenspan, it reacts more than one-for-one and the idea was that sensitivity heightens the sensitivity of policy and people's reaction to inflation. But here we saw that deposit rates also kind of look like that.
I thought the timing was sort of better and if you think that people's deposits are an important part of their savings, which it is an important, you know, aspect of transmission of monetary policy, it crossed our mind that maybe another thing that could have gone in there is that deposit rates did not react at all. And we knew that Reg Q was there. So we start to think maybe that has something to do with the macro of the time and the inflation. You start to look, there's a lot of smoke and fire there.
Joe (12:11):
Before we get into the specific sort of discovery of your research, one thing that strikes me as interesting, and Tracy mentioned this at the beginning, which [is] we think of Volcker as the start of this sort of monetarist turn in policy in which the entire goal or the thinking at the time was, ‘Well, we can solve the inflation problem if we can solve the supply of money problem. If we can sort of get a handle on the supply of money problem, then inflation will take care of itself.’
Judging by what you're saying about credit controls, and this is how much we want to have in checking, this is how much we want to have in people's savings accounts. This is the cap on CDs.’ It felt, it sounds like this was brewing for a while, that it was very popular already for some time for policymakers to really think about like bucketing different types of money and keeping some sort of lid or handle on each of them.
Itamar (13:02):
The way we hear things now, I also had the impression that there was a lot of monetarism at the time. Looking for it, it’s after the fact not as much — [is] my impression. Certainly, these ideas are out there, but I feel like the monetarism specifically comes somewhat later, actually, if you read the way they talked about it, demand management, it often sounds not that different than we talk about it today.
What I will say is, I usually say this at the end of the talk, there was a lot by the end, a lot of looking at growth in the money supply and in trying to keep dampen[ing] down growth [and a] big part of the money supply and the most responsive are deposits. So, jumping sort of to something I usually say at the end, I think that I'm not a big fan of monetarism and I think most of mainstream macro and monetary is not, now it doesn't mean it's wrong, but I think monetarists a little bit doesn’t understand their own theory.
So what I mean by this is if you want to reinterpret what happened in terms of monetarism, so you start out with why do people hold money? This is like standard monetarism. So money pays no interest and so it's a dominated asset and must have some other use. And as you raise, or as you lower the interest rate, you make it more, you know, easy for people to have money and they can spend more.
So the thing is it treats each money as just number of dollars. But what you see in the Reg Q times, when you don't let deposits pay the interest that they want, each dollar is now missing a lot of interest. So in that sense, its opportunity cost is going way up. So people take out deposits, there's less dollars, but each dollar is much more money, much more dominated, than it was before. So though you have less dollars, the cost to people holding those dollars is way bigger when the number of dollars is smaller when this ceiling binds tightly.
And so that actually suggests that if you sort of don't make this jump of thinking about the number of dollars but the opportunity cost of holding dollars, the amount of money that's sort of burning a hole in people's pocket is actually much higher when rates were high and the ceiling was binding than when there were more dollars, but the ceiling was not binding.
Tracy (15:05):
The ghost of Milton Friedman is going to haunt us too on this podcast. Okay, well take that line of thinking or that pushback on the monetarist view and apply it to the binding Reg Q ceiling and inflation in the 1970s. So, you know, prices are going up but banks are restricted from paying out more deposits to savers. How does that impact prices?
Itamar (15:28):
The idea was that by not letting them pay the interest that they want, some deposits would leave the banks. That was in fact [the] intention, that is what happened, it was called disintermediation and so deposits would flow out. The idea I believe was that this would tamp down demand because credit growth was the source of excess demand and that would help just like raising the interest rate should help.
However, what we argue was, it led to the disintermediation, but instead of having a stronger effect on demand, or only an effect on demand, what it had a strong effect on was the supply by firms, by producers. Because it's been well-documented that each of the times that the Fed funds rate went above the ceiling rate, which happened a lot during this time period, so whenever they raised rates. Then as deposits flowed out, there were credit crunches.
Meaning firms wanted credit, banks wanted to raise more deposits, they couldn't pay the rate, they couldn't get enough deposits, so they started to ration firms, [so] credit became scarce and expensive. Now firms need credit to do business, I think that's kind of clear. So it's an input, think of it like oil, but a much more important input. If you can't get it, what do you do? You fall behind in producing things, you cut supply and you raise prices because it's more expensive to produce.
And so we show that each of these cycles where they raised rates, where the ceiling was binding, you see both inflation and a decrease in output. And then we look across firms and we show that more credit constrained firms raised prices more and cut output more, cut employment more, cut investment more, cut inventories more.
Joe (17:01):
Alright, let's talk about the data that you collected because it's a good story, right? The money leaves the banking system, supply of credit therefore becomes rationed and then you have all these supply side constraints and that contributes to inflation. It's a good story. What is the actual data that you looked at to establish your claim?
Itamar (17:20):
So there's the aggregate part of the data, which I think is important to see but for economists usually can't by itself be convincing because you're just looking at the time series for the whole country.
Joe (17:30):
Wait, you can't do economics just by looking at two big charts?
Itamar (17:33):
I think you could.
Joe (17:34):
I've made my whole career on that.
Itamar (17:36):
I think actually that's a lot of times very important and the most convincing thing to people but if you are in the business of being a skeptic, then that is not going to be enough. So we look at a lot of aggregate things, so looking at how deposits flowed out whenever the ceiling was binding, they flowed out more when the gap between the fence rate and the ceiling was more, we looked at unfilled orders or backlogs of orders that rose during that time.
So I don't know which of these you find the most compelling but then, like I said, the second part of the paper, we looked at the cross section of firms to say let's look at something that just compares firms that were more exposed to this problem versus less exposed, holding constant things that are aggregate like the Fed's credibility, like oil shocks — any of these things that you want to try to difference out in order to just focus on exposure to the particular channel that you think is at work.
Tracy (18:27):
So, just to be clear, we're talking about disintermediation and the idea that money can flow out of banks because they can't compete on deposits and then that could lead to less investment. But what about just savings itself? Like how does Reg Q and the deposit rate cap impact people's behavior when it comes to spending versus savings?
Itamar (18:50):
That was actually the first line of reasoning that we went through. So we actually had two papers on this, but I'm talking to you about the supply one, but I'll tell you about the demand one. So that also makes inflation worse because both effects go in the same direction, which I can tell you in a second how that happens.
So if you're thinking about saving, and let's say that for you, the marginal saving is deposits, which for people at that time, and even today, a lot of people it is, and you see the rate and you see that you're getting a terrible real rate — it’s way below the inflation rate, at times it was seven, eight, nine percent below inflation because the cap was like five, 5.5%, inflation was 14% at one point. That's just a complete disaster.
So that on the margin would push you to try to consume, not to save. So if anything, it makes people want to consume more. At the same time and for the same reason, there's less credit to firms, so they can't produce as much. Both effects go in the direction of higher prices. The production effect lowers supply, the demand effect increases, you know, would increase by itself total output but both of them are making inflation go higher so it's kind of a bad situation in that respect.
Tracy (19:58):
Right, and it kind of gets to the heart of how transmission of monetary policy is supposed to work because you're supposed to propagate these interest rate changes out into the system — rates go up, people are supposed to hold on to more of their money, but if you have a deposit rate cap, then that isn't happening.
Itamar (20:15):
Yeah, so what macro economists think of as a sign of dysfunction is when you have wedges. And here there's a giant wedge, there's a wedge between the rate that depositors get the savings rate and the rate that borrowers pay — the borrowing rate.
The economy always tries to push you to make those things equal. So if people are willing to pay you a lot for loans, then you pay people higher deposit rates and then there's more savings and the equilibrium is where they meet. But here you couldn't, it's like a big friction, sand in the gears.
So what you get is two rates, you get a low rate for savers and a high rate for borrowers. And so it's like asking was the rate too high or too low? Well, it was too high and too low and that's because of this wedge in between. That is a classical sign of a problem when you have different prices for the same thing on both sides and it's not coming together.
Tracy (21:05):
Wait, can I ask a devil's advocate monetarist question? If Milton Friedman was in the room with us right now, maybe he would ask this, but there must be a monetarist interpretation of the impact of Reg Q as well, which I imagine would be like, ‘Well, if you make deposits unattractive, then maybe you are inhibiting monetary growth — the growth of money supply.’
Itamar (21:28):
That was the way that monetarists saw that.
Tracy (21:30):
And you saw no evidence of that?
Itamar (21:32):
No, I think it's the opposite. When they raised interest rates because this gap grew, it's always deposits were flowing out, it's the clearest thing in the data. So in that sense, it looks like you're reducing the rate of money growth but I'm arguing that it made each dollar, if you want to have that monetarist perspective, each dollar much more money-like. Do you mind having dollars if, you know, your deposits pay the Fed funds rate and you earn a real rate? It's not a big deal. If they're earning minus 8% real rate, that’s really money-like, it's really bad. You have to sort of think, what was the point of monetarism?
Tracy (22:05):
It’s like the nature of the money kind of changes almost.
Itamar (22:08):
I think it becomes more money.
Joe (22:09):
I mean this is like, they used the term hot potato, right? People didn't want to hold... Quick question and then a longer question, was this an extremely profitable period for banks?
Itamar (22:18):
Surprisingly, I don't think it was that profitable and it's a good question why, but I think also the real rates at which they lent out, for example, for long-term mortgages and stuff, which is what a lot of SNLs did, were also lowered by this kind of thing. So actually at the time people thought that when you get rid of Reg Q, it would make the banks very unprofitable. I'll tell you what it did do, it led to the SNL crisis. So I guess they should be, it's well known that lifting the ceilings on deposit rates left SNLs having to pay fair market rates, which made a big hole in their balance sheet.
Joe (22:56):
Getting back to your supply side analysis, and you mentioned you sort of tried to go sector by sector. Who would be particularly in, all things being equal, who is exposed to this sort of severe rationing of credit from the banking system having less money. What did you find when you look at the sort of sectoral breakdowns, what kind of things pop up?
Itamar (23:18):
So I should be specific and say that the database we have, because we needed a database of lots of information, is the NBRCES database on manufacturing industries. So, already it's all manufacturers. So we need the prices they charge, and we need stuff on their inputs. And so it's all different kinds of manufacturing and the construction of our measure are companies that need to pay a lot upfront in terms of production costs and labor costs, relative to the money they would have from the last cycle of selling, relative to the operating margins that they have.
So I don't remember exactly which ones were like high, if it was like textiles versus, I think like tobacco was low, but so I can't say that that among manufacturers, I could tell you exactly which ones were more and which ones were less. But you'd think that somebody carrying a lot of inventory, a lot of upfront costs would need a lot of credit and somebody who doesn't at all, you know, maybe tobacco manufacturers, it's not as big of a deal.
Tracy (24:16):
So you had less investment because of the disintermediation dynamics that you described. Meanwhile, you also had people spending more because they're not incentivized to save their money and put it in deposits that are less than inflation. That seems like a bad dynamic.
Itamar (24:30):
Yeah, I think it’s quite a bad dynamic, yeah.
Joe (24:35):
Okay, well this is great having you on, I really appreciate it. Now I understand the ‘70s.
Tracy (24:40):
Okay. Wait, when you did the research, I mean, did you find one of those factors — like the supply side versus the demand side — which one was bigger?
Itamar (24:46):
You can see in the aggregate data that the net effect, meaning the one that overwhelms, is the supply one because — and this part I think is not new — because it, despite all the narrative focusing on the Fed's inability to control demand, the four cycles in the sixties and seventies, which are the stagflation cycles, were called that because each time that inflation went up, output was dropping at the same time.
By the way, it's quite different than what we've seen recently. So that well known and so you, when we first started, we're like ‘Why do they keep talking about demand when clearly output is going down?’ But the reason people say that is because they took the decrease in output as basically exogenous, like stuff happened, like oil happened, before there was some other crisis that happened and so they're like, ‘Okay, well we can't do anything about that. That's just our job, the Fed's job to deal with that.’
And so in light of these various supply shocks that apparently kept happening, the Fed didn't do a good job at controlling demand. Whereas we're saying these supply shocks, it's happened all the time and it happened in this fashion. It's not a coincidence, actually. It was a huge financial friction that made this happen.
Joe (25:55):
You know, you mentioned, if credit is going to be rationed, investment is going to go down. Investment is also a demand impulse, right? So building factories is, you know, that's someone else's income, that's activity. Companies going out of business and laying off workers, we would think would be disinflationary, right? So why is it that, as you describe, you have this sort of rationing of credit, this credit constraint that hurt a lot of manufacturers. Why? I mean, just intuitively that sounds like it could be a disinflationary story.
Itamar (26:26):
Oh, absolutely but we actually are not emphasizing the investment. That is there, but we're emphasizing the ongoing operations. So I think classically, oftentimes people think of credit as going to investment, but most of the credit, the stock of credit firms, is like working cap, not just working capital, but you pay upfront for a lot of things.
Like just to take an extreme case, if you deal with a contractor, you pay them usually half upfront. It's not like you tell them ‘Yeah, go build my house and when you're done, I'll pay you.’ So people pay for materials and labor in large part — this is where trade credit comes in and all these things — companies need a lot of credit front. So we're talking about the direct operations of the firm. It is also true that you saw a decrease in investment and like you're saying, that by itself could be interpreted as lower demand. So it's not our emphasis in this part.
Joe (27:13):
So, you know, going to when Volcker came, and I've been plugging this a lot lately, but I finally read the book Secrets of the Temple and it totally changed my perspective on like at least the first few years of the Volcker regime because it was not actually a simple story of like, finally we're going to get tough. It was just like all of these levers being pulled and the huge swings in the Fed funds rate, the first few years seemed like a total mess. What did actually then, in your view, create the real durable turn in inflation?
Itamar (27:50):
So yeah, we look at this in both papers. I think the timing lines up very well. I would say, this is heresy now, it's better than the Volcker rate hike with the two stages of the deregulation of Reg Q. The first one being the first major deregulation at the end of 1978 and 1979 and then for this one, the total essentially getting rid of almost the rest of it at the end of 1982.
And both were associated with huge inflows of the respective deposits that were deregulated and we look at banks that benefited more from this versus less and sort of see the unwind of what we are seeing before, and then connect it to firms that were located in areas, that were able to borrow from those banks, as well as the ones that were more financially dependent in areas that were more affected by the deregulation.
And they show the unwinding in these so that they increased production and raise prices or cut prices, or you know, raise prices less or cut prices more than the other ones. And I think if you look at, and you know, inflation's very messy now that we've gone through it, you can see how hard it's to know exactly where it is. Inflation starts to come down at the end of ‘79, beginning of ’80, several quarters before Volcker’s big rate hikes. So that is not going to convince any monetary person of my story, but I do think that it's there if you want to be convinced.
Joe (29:16):
The market was pricing it in preemptively. Efficient markets.
Itamar (29:21):
Well, I'm talking about the inflation.
Joe (29:23):
Yeah no, you're right.
Itamar (29:24):
I think bond markets didn't think that Volcker had won until like mid 1984. So 10-year rates were as high in mid ‘84 as they'd been before Volcker raised rates.
Joe (29:36):
Tracy, that's when Bill Gross slammed the accelerator, as we talked about. No, right? The rates stayed really high and that's when he said, that's when he knew the moment was like go all in.
Tracy (29:45):
He knew, he knew. I want to bring us up to present day because, I mean, it's very useful to have this overview of the 1970s, but maybe there are some lessons here that we can apply specifically to what's happening now in 2023. And let me start with a really simple one, which we've discussed on this podcast before, notably with Barclays’ Joe Abate, the money market strategist.
We don't have that binding constraint of Reg Q anymore and yet it feels like it's been a relatively slow process to see banks in the US raise their deposit rate. And I was looking before the show, the average bank rate, according to Bankrate.com on retail deposit savings accounts is still only like 0.58%, which is kind of crazy. It's higher on certificates of deposit and money market funds and things like that, but why aren't we seeing more of a pass-through from higher benchmark rates?
Itamar (30:38):
So actually, a lot of work we've done is on this and the effect of this in times after Reg Q, that's where we started with. I mean, the simple answer is they have a lot of market power and so people aren't leaving despite the lack of higher rates. You saw after SVB that there's a lot of discussion that now people will wake up to the fact that rates are really low, they'll demand higher rates.
Tracy (31:00):
It still hasn't really happened.
Itamar (31:01):
No, it really hasn't. It happens at some small banks, but I was quite skeptical at the time because everybody can't be asleep, and they just wake up. Like I know we all listen to Odd Lots but more people still, the majority of the world is still not listening, so your market share could grow a lot.
Tracy (31:18):
I'm going to renew my call to improve the transmission of monetary policy and defeat inflation. We all need to find a savings account with a high interest rate. So go out and do it, do the market research.
Itamar (31:31):
They have a lot of market power, it's a very big part of the banking business. The difference is that they could raise it if they wanted, if people became aware, if they left banks to go to other banks and so that's a response, that's their optimal response. Whereas in the seventies, they wanted to raise the rates and couldn't and that's very different. So they were kind of like a super monopolist, but so much of a monopolist and they didn't want to be like, even a monopolist doesn't want to set the price so high that they can't sell anything.
Joe (32:16):
So thinking about now versus the 1970s, there are two ways that I could think of that maybe the economy is fundamentally different. But let me start with the one that's sort of most directly [related] to this. In the late seventies, the banks were probably like the main game in town for credit. Whereas today there's all kinds of different ways that a firm of any sort, even a manufacturer, there's the bond market.
Tracy (32:39):
The bond market would be a big one.
Joe (32:40):
It’s exploded since then. We talk about private credit and private lending, etc. Talk to us, like just start, how much more important were banks for the provision of credit in the time that you focus on then versus today?
Itamar (32:52):
So I do think they were more important, I want to push back a little bit because I've learned myself over time, certainly the bond market's bigger and certainly there are other non-bank sources of credit. However, I do think that the diminishment of banks’ importance has multiple times been overstated.
Just to give you some data, I looked into this. So there are about 1000 firms in the US that are rated, meaning that they can issue bonds. Out of the about 3,500 firms that are listed on the stock market, there were about half as many firms that could issue bonds by the end of the seventies out of about 4,500 firms that were listed. In any case, that's not that many firms, they are gigantic on average. So in terms of [valuations], they're very important. But there are about 700,000 firms with over 20 people, which means that 699,000 of them cannot issue bonds we're
Joe (33:48):
We’re talking about today?
Itamar (33:49):
And there were about 350,000 firms at that time that were above 20 people, and so couldn't issue bonds. And so, although there's been an expansion of this, the vast majority of firms — people call them small firms, but that makes you think of like a laundromat — they get a lot bigger than that. So small medium/firms cannot, it's just very few even out of the stock market. Like I said, two thirds don't issue bonds.
Joe (34:11):
So even today there is a huge pool of companies that really, if they need credit, need to go to a bank or something like the bank. Now, the other way that maybe the economy feels like it could be different than the 1970s is huge drivers of you know, the US economy maybe are less credit center.
I'm thinking like tech for example, or software in which we don't really associate them with like borrowing. Was the economy inherently more credit-sensitive? I would imagine in a manufacturing economy you have to build factories or even just maintain inventory. Were more companies in perpetual need of credit than today?
Itamar (34:51):
I don't know the answer to that. I would've actually guessed that with financial deepening in general we’re more financialized. I should just say, just to not give the wrong impression, I don't think that the inflation of the last couple years was due to financial friction per se. I think the analogy is, and I believe this for a long time, that the main driver was the supply chain shocks.
It's in that respect that I think it's similar. I make the increase in demand due to transfers or fiscal. I always thought that was secondary. I thought that once the supply chain gets solved, the effect will be largely a diminishment of that. So that has been my opinion. I think more people are there now than they were like a year ago, but that's the analogy the way I see it.
Tracy (35:33):
Just to press on this interest rate sensitivity point, I know I mentioned before that we've talked about Reg Q in passing a few times with Josh Younger and Lev Menand in one or two other episodes. But if it sounds familiar to our listeners, it might also be because it came up in a very famous speech made by Ben Bernanke in 2007 where he was talking about how sensitive the housing market was to changes in the Fed funds rate. He basically said, because we don't have Reg Q ceilings anymore on deposit rates, that means that deposits are a much-diminished source of housing finance, so everything is going to be fine. And that turned out not to be the case.
Itamar (36:14):
So it's true that Bernanke — and if you actually go back and read his papers from the eighties and not just him — there's a lot of understanding that Reg Q made it so that housing was very credit sensitive when Reg Q was there. So for the reason we said, banks would lose deposits, one of the main forms of bank lending is mortgages and also loans to contractors. And so you would see, you know, [the] house market basically dry up and then when deposits came back in, housing would be on a tear.
And it was the impression of a lot of monetary people that once Reg Q was abolished in 1982, first this was the reason we didn't see these kind of wild gyrations anymore and also, they assumed, which I think was wrong, that deposits would transmit policy [more] than, you know, one for one. Which was sort of true, right, when Reg Q was abolished and became less and less true to your question of why deposit rates are so pathetically low now.
Joe (37:07):
Well, going back, I mean, policymakers must have seen this wedge that you're talking about in real time, and it must have sort of been obvious that they could keep hiking rates to fight inflation, but it would have minimal impact on actual rates of deposit that people got. What were they saying at the time? Was there an awareness that this was a tension, that this was impeding the transmission of monetary policy? And if you said that, as you pointed out, historically, they would sort of lift the cap over time along with the Fed funds rate, why wasn't it lifted?
Itamar (37:40):
So a couple things, I think they definitely saw the credit crunches. They actually didn't like those, weirdly, even though they wanted there to be less credit, they just didn't want it to be like that hysterical. So I think they thought this was helping — partly that the monetarist view would tell you, look, there are less deposits, so less money growth and this should be helping inflation.
And of course, whenever they eased up, the deposits would flow back in, which would look like a lot of money creation so this was kind of annoying them very much. I tell people it's like giving a sick patient the medicine. Well if they get sicker, there's two conclusions and unfortunately they're diametrically opposite. One is that the medicine is not working, the other one is that you didn't give the patient enough medicine. So if the medicine's making them sicker, the second one's not going to be that good.
And if you read, they thought that there must be lots of other avenues [through which] banks are able to circumvent this. One view was that this is like barely holding the dam and that these guys are finding lots of ways around it. If you look at total credit growth, they did not find many ways around it. They did many things that you guys have mentioned, like the beginning of money market mutual funds, the eurodollar. Many, many financial innovations come from this time period. It's actually a really interesting time period. But they did not actually circumvent it that much.
Joe (38:53):
Tracy, this is a real diversion, but, you know, after college my first job was in a natural food’s grocery store.
Tracy (39:01):
Oh, I've heard your sandwich stories. Joe.
Joe (39:03):
This is not a sandwich story. I just want to say I've been around a lot of people in my life that did very strange, like self-medication to like treat a sickness and they would get worse and worse and convince themselves that they're getting healthier and healthier. So I feel like ‘Oh, I'm just like, going to like do nothing but like take Golden Seal or like eat spirulina’ or something like that, and they get sicker and sicker and more emaciated and it's like, maybe it's not working? Anyway, I just understand that phenomenon firsthand.
Tracy (39:33):
Thank you Joe, for that insight.
Joe (39:35):
I want to, you know, just sort of wrap it up, this idea that Reg Q, as you describe it, had really two effects and there was the demand effect because the hot potato effect on money, it's like, it was just terrible to hold cash and so you spend it. Then as you mentioned it the sort of supply chain side, the supply disruption — raising the cost of capital for companies and then companies have a markup and then so went beyond that.
How do you just sort of establish that it wasn't mostly the demand side? Because I think, you know, you say well there's this consistent throughput. Maybe the story now is the story then [of] supply-side impairment. But as you say, you also found this demand effect from the failure to transmit monetary policy effectively, what gives you the confidence that it wasn't just that hot potato effect?
Itamar (40:24):
Well, on the net part it’s just that you see that as inflation's going up, output growth is going down, including negative output growth. And then we have this chart at the beginning where you see unfilled orders going up and up, which could by itself look like a lot of demand, but at the peak of unfilled orders is when growth is negative.
Joe (40:43):
What year is this?
Itamar (40:44):
This is actually throughout the whole time period. If you look, it tracks. Unfilled orders lead inflation by a quarter or two in a way that’s just beautiful and it's the quantity of unfilled orders, so we're deflating it by prices. It’s not a mechanical effect. So if you just look at it, it goes up and inflation follows and when it peaks and starts to go down, inflation starts to decrease. And like I said, all else equal, you might think, well, people are just ordering so much but actually output growth is falling and even negative at the peak of this thing.
Tracy (41:12):
Let me ask a question to sort of sum it up. But we started this conversation talking about how the memory of the 1970s inflation, the traditional interpretation of it, kind of looms large in a lot of people's minds, especially policymakers and economists and academics. Looking at it through the lens that you described, what should be our biggest takeaway of that period and what should the lesson be for 2023?
Itamar (41:39):
It's a hard question. I’ll tell you some of the inferences I make, I think that the focus of monetary policy and the way it understands history’s mostly through excess demand causing inflation and variation in demand causing business cycles. And I think, there's a lot of evidence that many times supply was just as important, if not more, in driving both in inflationary episodes and business cycles.
And actually, although it didn't happen this time, credit crunches, of which many of the business cycles, if you look at people who do history in the post-war business cycles, many of them involved credit crunches of one form or another. And I guess there to say is that monetary policy in that, with the financial friction, can have an impact on supply, not just demand.
In terms of looking forward, for example, we had supply chain issues, unfilled orders. I would look for those kinds of things. If we have more of those going forward, I would get very worried, like the auto industry was a perfect proxy. So long as autos weren't being produced anywhere near the level they were before, I felt like that's an indication that the problem inherently is still there. If we were to go back to that I'd be quite worried about it.
Joe (43:00):
Itamar Dreschler, thank you so much for coming on Odd Lots. You're going to have to maybe send us some of these charts because I think that's fascinating. The idea that right now, like, it is tough to disambiguate between supply. Is it too much supply? Is it too little demand? But if the worst of the inflationary waves of that period were actually periods of declining growth or declining rates of growth, that sounds like a strong indication, so we got to show that. Thank you so much. That was a great conversation.
Joe (43:43):
Tracy, I really enjoyed that conversation. I mean there's obviously a lot there, but it also just generally seems to be the case, like, we can't always talk about 1970s, 1970s without really like digging into [it].
Tracy (43:53):
Oil shock! Money supply!
Joe (43:55):
You know, they severed the gold….
Tracy (43:58):
Oh, gold standard. I forgot about that one.
Joe (43:59):
Gold 1971, oil shock. All these, you know, spendthrift Keynesians running around and then finally stern tall Paul comes in and lays down the law and it sounds like those, you know — oh, and unions of course and unions demanding that they get a pay rise, the cost-of-living adjustments [and] so forth. There's a lot there and it’s all sort of this big soup of ideas. So it's sort of helpful to actually think about like, okay, let's talk about how monetary policy worked back then.
Tracy (44:27):
Right, totally. And I also think unfortunately, except to a select few, maybe us two and a few other people, Reg Q is just not that sexy a topic, compared to the gold standard and things like that. So I can see why it hasn't been a focus of a lot of research historically when it comes to the 1970s period of inflation. I also have to say, you know, a lot of what's going on right now with the discussion over interest rates and inflation, it feels like the same people who are sort of complaining that rates are too high now, are also the people who were complaining that rates were too low.
Joe (45:01):
For the last 15 years.
Tracy (45:03):
For years! And so the wedge idea, like the idea that rates were both kind of too low and too high or just like not well suited to the problem that was trying to be solved, is a very attractive one to me. Like, it feels a lot more nuanced.
Joe (45:19):
Absolutely. Also, it's just sort of interesting to think of the cost of credit as a business input. As Itamar mentioned, it's not going to be conducive to a boom if you have companies literally going out of business or not building new factories. But if you have operations, ongoing operations that require credit to continue going and the cost goes up, it doesn't destroy the business, then it sort of makes sense that, you know, that that comes through as a higher cost.
Also, it sort of fits in these days maybe a little bit with some of our conversations about housing and real estate and the impairment of new development. And then now, we see how as prices going up and why do we never have enough housing supply to have sustained deflation or disinflation in shelter? It still feels like that sort of rate component of supply, it still matters at least in some way.
Tracy (46:09):
Well, now that we're done trashing Paul Volcker's legacy, shall we leave it there?
Joe (46:15):
You know, he did some good things. Let’s leave it there.
You can follow Itamar Dreschler at
@idreschs
.