The Great Crash of 1979 – Podcast 474

by | Mar 3, 2024 | Podcasts

The Great Crash of 1979

Key Take-aways from the Great Crash of 1979:

1. Paul Volcker dramatically changed the direction of the US economy by focusing on controlling inflation, rather than maintaining full employment.

2. Volcker’s secret Federal Reserve meeting on Saturday, October 6, 1979, resulted in a significant and unprecedented increase in the Fed Funds rate to combat inflation.

3. G. William Miller, Volcker’s predecessor, was more focused on economic growth than inflation control, which contributed to the problematic economic conditions of the late 1970s.

4. The 1970s saw a series of economic challenges, including the Vietnam War, Great Society programs, the end of the gold standard, oil crises, and ineffective wage and price controls.

5. Inflation rates in the 1970s escalated from 2-3% to over 10%, while the Fed’s strategies lagged behind, failing to effectively manage the rising inflation.

6. Volcker’s approach to raising interest rates to levels above the inflation rate was a significant shift in Federal Reserve policy  – influencing its actions for decades.

7.  The primary shift which triggered the Great Crash of 1979, moved the Federal Reserve from tweaking the “money supply” in the system with use of a trailing discount & Fed Funds rate, to draining money supply and an aggressive Fed Funds rate to strangle inflation rates.

7. The immediate aftermath of Volcker’s policy changes led to the “Great Crash of 1979,” a recession, and high unemployment, but ultimately succeeded in controlling inflation and setting the stage for economic growth in the 1980s.

8.  The “Great Crash of 1979” made for a famous NY Times headline, but markets have moved far more dramatically since then.  The events of October 1979 marked an important turning point for financial markets.

Interesting points which did not make it into the episode “The Great Crash of 1979” –
In the early months of 1979, month-over-month CPI increases showed a (short-term) inflation rate of 13%.  Yet, at the May 22, 1979 meeting, two FOMC members voted AGAINST shrinking the money supply, and came out in favor of easing monetary policy (?).  – FRBSF Economic Letter(12/2004)

Central bankers learned through the “great Crash,” that maintaining low inflation IS their primary responsibility.  – FRBSF Economic Letter(12/2004)

In 1975, years before the “Great Crash,” the Fed was required by Congress to establish “target growth rates” for the money supply, to report the targets to Congress, and, if the targets were not met, to explain why not.  – FRBSF Economic Letter(12/2004)

Volcker fought very hard for the Federal Reserve to maintain independence, a point which is continually challenged today, 45 years later.

 

The Great Crash of 1979 – Links

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FRBSF Economic Letter #2004-35, December, 2004 (Federal Reserve Bank of San Francisco)
Federal Reserve history – Volcker
Federal Reserve History – Miller
The Reform of October 1979: How It Happened and Why (Lindsey)
Reflections on Monetary policy 25 years after October 1979 – Minneapolis Fed

The Great Crash of 1979 – Transcript

In this episode, we’re going to talk about the great crash of 1979 and how Paul Volcker single-handedly changed the direction of the US economy.

“In a rapidly changing world, the opportunities for making mistakes are legion.”

This is a quote from Arthur Burns, who was chairman of the Federal Reserve from 1970 to 1978. As I was preparing to do this podcast episode on Paul Volcker and the great crash of 1979, I was reminded of that quote from Arthur Burns, the former chairman of the Fed.

Again, “In a rapidly changing world, the opportunities for making mistakes are legion.”

This is the story of how Paul Volcker put the Federal Reserve back on track – in one meeting, in 1979.

It’s a story of how Volcker changed the direction of the Fed.
He changed the direction of interest rates.
He changed the direction of the economy for the next twenty years.

Volcker announced a secret, unscheduled meeting for the Federal Reserve members to be held on a Saturday.
Saturday, October 6th, 1979, that meeting changed everything. And it’s a pretty good story.

Volcker had practically just become chairman of the Federal Reserve at that time. He was sworn in on August 6th, 1979. So just two months later, he has this secret meeting that changes everything.

Volcker already was a member of the Federal Reserve Board. At the time, he was chairman of the New York Federal Reserve Bank, so he was automatically a member of the Federal Reserve. But the Federal Reserve chairman at the time was a fellow named G. William Miller, and he was on his way out. Miller was only on the job for one year.

In the summer of 1979, Miller was appointed secretary of the treasury. He basically got kicked upstairs. You can still see Miller’s signature every now and then on some dollar bills that are still in circulation forty years later.

Miller was essentially in the wrong place at the wrong time as Fed chairman; again, he only lasted a year. He was pretty well regarded as an expansionist, meaning Miller was way more interested in promoting economic growth, rather than fighting inflation; it didn’t seem like a problem to him.

He believed that the Fed should take measures to encourage growth and investment, even if that growth came along with some additional inflation with it. Miller believed that inflation was caused by a lot of different factors that were just (simply) beyond the control of the Fed.

In some ways, Miller was a throwback to the way things used to run at the Federal Reserve. In the 1960s and then through most of the 70s, the main thought at the Fed was to keep unemployment as low as possible. And that became their primary objective for this period from the 60s through the 70s.

I’ll say it again, “In a rapidly changing world, the opportunities for making mistakes are legion,” and the fact that they remained focused on keeping unemployment as low as possible – and keeping the economy at full employment; really wound up costing everybody in terms of inflation.

So through the 1970s, the Federal Reserve wrestled in a three-way tug of war between keeping unemployment as low as possible (that was their primary objective), secondly – growing the economy, and then third, to some degree, containing inflation.

The best way the Fed thought to do that was to continually make credit available – to expand the money supply and keep interest rates relatively low. And the thought was, “If we get some inflation, that’s just the price of keeping people employed.”

So the concept at the Fed was to “run the economy a little hotter than normal” by doing these things like keeping interest rates low and making money available. Their target was to keep unemployment in the 3% to 4% percent range, which didn’t always work. (For example) during the recession in 1975, unemployment reached nine percent. So the Fed was pretty ineffective when it came to keeping a lid on unemployment, and the price the Fed would pay for focusing on unemployment would be gigantic.

The ever-low interest rates, and the continued increase in the money supply brought with it huge waves of inflation. In 1970, the economist Milton Friedman, who was almost always at odds with the Federal Reserve, wrote this approach of “running the economy hotter than normal” would work – for a while. But (he added) it would end very badly.

And it did end very badly, with inflation rates (later) in the teens.

So in a short span of time, think back to what happened in the 60s and into the 70s:
We had a huge budget increase to pay for the war in Vietnam.

We also had to pay for the new programs coming out of the Great Society project, Medicare, Medicaid.

We also ramped up NASA and the space program during this time.
And then a few other things happened.

The United States went off the gold standard, thanks to Richard Nixon in 1971.

In 1973, we saw the Yom Kippur six-day war. And out of that, we saw OPEC rise to some power. They started flexing their muscles, and we had an oil crisis.

President Nixon also imposed wage and price controls in 1971, and he did it again in 1973.

Now, this had the effect of temporarily lowering the rate of inflation. But the problem with these temporary moves was a lot like “coiling a spring.” Eventually, when the price and wage controls came off, inflation came roaring back, hotter than ever. And at that point, a lot of people learned, especially when it comes to economics, that when you pass a law or use an executive action like price controls and wage controls, you’re not really addressing the actual problem.

Think about that.

In the time leading up to 1979, we saw inflation move from — it had been in the range of 2% to 3% per year in the early 60s. And then inflation was in the 5% annual range from 1969 through 1973. And then from 1974 through 1978, inflation averaged 8%, so we’re seeing these levels go higher and higher.

Then in the first eight months of 1979, inflation (averaged) 10.75%.

In September of 1979, inflation was eleven percent and continuing to climb. At the same time, unemployment — remember, this was the Fed’s primary target; had risen to 5.8% and continued to climb.

It’s with this backdrop that President Carter replaces William Miller with Paul Volcker as chair of the Federal Reserve. Miller, as I mentioned earlier, was only on the job for a year. Volcker was appointed, reviewed, and approved by Congress very quickly, and he was sworn in on August 6th, 1979, and he chaired his first meeting just a few days later.

Prior to Volcker becoming Fed chairman, the Fed was pretty ineffective.

Whenever they felt the need to “goose” the economy, they would increase the money supply. That is, they would put more money into circulation. The two other tools which they used — very sparingly — were the discount rate and the Fed funds rate.

The discount rate is the rate the Fed would charge a bank if they needed to borrow funds directly from the Fed on an overnight basis.

The Fed funds rate is the rate set by the Federal Reserve that banks can charge each other, when they need to borrow money from another bank on a short-term or an overnight basis.

The Fed was very slow… they moved at a glacier-like pace to raise either of these rates, the discount rate or the fed funds rate. But they began finally reluctantly nudging up these rates in 1979. But still, they were raising these rates at a pace that was not keeping up with the rate of inflation. Very similar to what we saw in 2022 from the Federal Reserve.

So Volcker’s first move in August of 1979 was to increase the discount rate by half a percent. Raising the discount rate by half a percent had never been done in recent times, so Volcker was already setting new terms for his role.

Volcker began imploring other members of the Federal Reserve board that they were fighting the wrong battle. Their focus was on keeping unemployment low; what they really should be focusing on is containing inflation. (As he said) “because we’re going to have a much bigger problem if we don’t get ahead of inflation.”

Volcker met a lot of resistance, but he believed that he was right. In speaking with President Carter, he explained, and I quote, “To break the inflation cycle, we must have a credible and disciplined monetary policy.”

And I think that’s really what the problem was with the Federal Reserve in the 1970s. At the time, the Federal Reserve was looked upon as toothless and timid; they were raising rates reluctantly. They were always behind the rate of inflation. But Volcker knew this was the only way to succeed, even though it would be unpopular. It would be a tough sell even to his fellow members on the Federal Reserve board.

So this all set the stage for a drastic immediate action that he knew he had to take.

In September of 1979, the Fed met, and they voted again to raise the discount rate. (However) when the decision was disclosed, however, that the vote at the meeting was four to three in favor of raising rates — market participants took that to mean there was a lot of dissension and different opinions about this new change in direction at the Fed.

Market participants took this as a sign that the Fed might be done raising rates and trying to curb inflation.

So it was bad because this sent (again) a weak signal to the market. Because while they were actively raising rates in the August meeting and in the September meeting, they were still falling behind the rate of inflation. There was just no way they were going to keep up at this pace.

And so with that, stocks slumped, bonds sold off. More importantly, gold, silver, and most other commodities skyrocketed, thinking inflation is going to continue to run higher and run for longer. And the dollar fell versus other currencies.

The very next week, Volcker was attending an IMF (International Monetary Fund) conference in Belgrade. When he got to Belgrade, Volcker was scorched by the other financial leaders around the globe, because when the dollar fell, it made all these other currencies that are measured against it much stronger.

This created inflation in other parts of the world – that didn’t really want it, and it made their cost of doing business, their trade, a lot weaker.

So Volcker gets blasted when he goes to Belgrade. When he comes back, he knew he had to take some drastic action. And so Volcker comes back to the United States. It’s October second or third, and he decides I’m going to call for a special meeting, this secret meeting of the Federal Reserve board.

And he set it for Saturday, October 6th, the next Saturday.

And Volcker laid his argument out very plainly to the group. “Look, we have to decide.”

Would the Fed stick to its interest rate target, or would we stick to its money growth target? This was a very big deal.

He insisted the Fed needed to change their overall focus from keeping the economy at full employment to “getting a grip on inflation.”

And this is a change at the Federal Reserve that has remained in place for the next forty-five years. This really provided a roadmap for current and future Federal Reserve boards on how to act quickly, and act with some gusto.

As I was getting ready to do this podcast, I was reminded of a scene from a movie — which incidentally came out in 1979.

The movie is “Escape from Alcatraz.” This is a Clint Eastwood movie. If you’ve ever seen it. he plays this character “Frank Morris,” who has broken out of a lot of jails, and he’s finally sent to Alcatraz. And he is a very thoughtful guy.

One day he meets his group of friends at a table in the cafeteria, and he says, very deadpan, very hushed, says the following line:
“I think I may have found a way out of here.”

And the guys all look at him in stunned silence.

Alcatraz was a place you could not break out of. And for the next minute or so, Eastwood’s character explains his plan in a very hushed voice. The guy from the next cell is also sitting next to him at the table, his name is Charlie Butts, and asks, “What are our chances?”

And Eastwood, Frank Morris, replies, “They’re slim.”

And instantly, the whole group, one by one, immediately answers, “I’m in.”

Even though their chances were slim, they all wanted to do this. They wanted to move in this direction,

And this is what I imagine happened with Volcker, now chairman of the Federal Reserve, at this special meeting on Saturday, October 6th, 1979.

At this meeting, the Fed agrees — in a unanimous vote — to raise the Fed Funds rate from 11.5%, where it was currently, to 15.5%!
A four hundred basis point move, in one shot.

This kind of move was unheard of in the history of the Federal Reserve, going back to 1913. Along with this, Volcker announced they would continue to raise the fed funds rate, to stay above the rate of inflation, for as long as it took. The Fed Funds rate peaked roughly six months later, in April 1980, the rate peaked at 19%, and for most of 1980, it averaged 17.5%.

Volcker didn’t see a path to lower rates until 1982.

The immediate aftermath of this decision was what the New York Times dubbed the “Great Crash of 1979.”

Stocks sold off immediately. People heard of this surprise meeting, and they wondered “what in the world is going on?” I mean, that sort of thing just never happened. The Fed met in secret, and they met on a Saturday. What’s this?

Obviously, they’re taking this problem very seriously. That’s good.

So stocks sold off immediately. They went down just about every day for the next week. Bond prices did even worse. They cratered.
The Dow Jones was down almost seven percent that week. Bonds were down even more in price.

Moreover, there was a price that had to be paid for raising rates so aggressively. They raised the rates in October 1979, and by January of 1980, just three plus months later, the economy was already in a full-blown recession.

And unemployment — remember, unemployment was their original goal at the Fed — unemployment peaked at 11%. So after a small recovery, at the end of 1980, the economy again slid into a much deeper recession. Inflation remained active (persistent). It didn’t really subside as easily as a lot of people hoped.

The Fed and Paul Volcker didn’t feel it was really appropriate to lower rates until, and I remember the date, August 16th, 1982. That period of time, and that aggressive action on Volcker’s part, was enough to beat inflation. And kick off a roaring decade in the 1980s, a great economy, and a twenty-year bull market in stocks.

There’s a lot of lessons in the great crash of 1979, and the steps that were taken by Paul Volcker to get the US economy on track and contain inflation.

I had a lot of help putting this together. I’m going to link to a couple of great articles in the show notes.

I hope you’ve enjoyed this episode regarding Paul Volcker and the Great Crash of 1979.  Let me know. This is a little different departure from what we’ve typically done on our podcast. If you enjoyed this, please let me know. I would love to get any kind of feedback that you have on this. And thanks again for listening to this week’s podcast.

Tom Mullooly is an investment advisor representative with Mullooly Asset Management. All opinions expressed by Tom and his podcast guests are solely their own opinions and do not necessarily reflect the opinions of Mullooly Asset Management.

This podcast is for informational purposes only and should not be relied upon as a basis for investment decisions. Clients of Mullooly Asset Management may maintain positions in securities discussed in this podcast.

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