It must’ve seemed unimaginable at the time, another dreadful contribution to the early lives of an entire generation who couldn’t seem to find peace and stability. Having first suffered the Great Depression, then fought to the death in World War II, was it really too much to ask that by 1950 regular folks wouldn’t need to suffer both economics and war again?
Seemingly out of nowhere, Communists in the north of Korea poured over the ceremonial border which had separated them from their southern peninsular kin. The first barrage of what would be called the Korean Conflict assaulted more than just enemy positions in the hours of June 24, 1950.
Before then, the US economy had suffered a serious setback in 1949, and for the first six months of 1950 rather than descend toward Great Depression #2 as some had worried, it roared back to life with unusual vigor. According to modern estimates (BEA), in Q1 and Q2 1950, seasonally-adjusted quarterly real GDP increased at annual rates of 16.6% and 12.8%, respectively.
Consumer spending (PCE, or personal consumption expenditures) only accounted for a fraction more than 4 percentage points of each of those quarterly gains. Over half of the Q1 increase was inventory restocked after the ’49 recession lows.
Then came the war.
Americans responded to the news by absolutely binging on goods. Consumers shopped for all they could find, and then went out and bought some more.
The BEA says Q3 1950 GDP again surged this time by another enormous 16.4%, of which 13.4 percentage points was due to people buying mostly durable goods.
Hardly gluttonous, the US public knew full well what war in Korea would mean for their own households. Having suffered through the prior conflict ended only five years earlier, memories had remained fresh and sharp as to the forced privations which quite naturally surround any truly national struggle.
Having been teased with a real taste of post-war prosperity up to the first half of 1950, normal Americans just as naturally sought to obtain every last bit of comfort and modernity between the time when the North Koreans invaded and the inevitable US government edicts restricting goods and access which were surely and quickly to follow.
On July 19, 1950, President Harry Truman spoke to both a radio and TV audience to begin preparing the country for the grim reality of its near-term.
“The things we need to do to build up our military defense will require considerable adjustment in our domestic economy. We have a tremendously rich and productive economy, and it is expanding every year…Our job now is to divert to defense purposes more of that tremendous productive capacity–more steel, more aluminum, more of a good many things.”
The Defense Production Act was swept into law that September.
Whereas consumer binging (PCE) in Q3 1950 had been responsible for increased activity, in Q4 such was maintained by business; PCE subtracted a huge 7.72 points from Q4’s still-robust 7.9% quarterly rate which instead had been saved by inventory accumulation adding back an even larger 11.1 points.
Hyperactive consumer spending would return in Q1 1951 (+5.5% real GDP; PCE contributing +6.32 pts) and then inventory again in Q2 1951 as the public pulled back one final time (+7.1% real GDP; PCE subtracting 6.88 pts while inventory added 4.57 pts back) before the frenzy was over.
Prices, especially goods prices, absolutely surged. The BLS’s CPI measure of “inflation” had been negative (unadjusted) on a yearly basis for June 1950, -0.42%, given an economy just beginning to shake loose from the final effects of that prior recession. With fighting erupting halfway around the world and the US government mobilizing its authority in July, the CPI turned immediately positive with a positively accelerating 1.69% increase.
The seasonally-adjusted CPI figures show an enormous bulge beginning in July 1950 and lasting until February 1951. Using this data, the aggregate price level had increased by more than 8% in just eight months, a peak annualized rate above 12%.
Neither out-of-control money nor government recklessness had caused this “inflation.” As to the latter, the federal government and defense industries wouldn’t fully mobilize until the CPI was on its way back down the following year. On the contrary, classic supply shock; or demand shock, if you want to characterize this sudden surge in buying an increasingly restricted supply side couldn’t easily meet for almost entirely non-economic reasons.
For their part, policymakers at the Federal Reserve drew a line in the sand on these consumer price changes. Since the outset of WWII, the US “central bank” had been relegated to the backburner, placed (with very good reason; see: Great Depression) under the suspicious thumb of the Treasury Department. For the remainder of that earlier fight, the Fed’s lone job was to make sure the government could sell any amount of debt the war effort demanded.
Ostensibly, monetary policy was left to little more than maintaining a ceiling on government interest rates; an explicit policy for bills and short-term debt, more implicit in the longer run stuff.
Given that prior depressionary backdrop, however, this wasn’t actually any problem, meaning the Federal Reserve found itself with practically nothing to do. The banking system, still seeking only the safest and most liquid profit opportunities, was only too eager to buy each and every bond, note, and certificate – at almost any price – Treasury had to sell.
Far from any patriotic contribution to the American cause, bank behavior was merely reflecting the economic and financial realities of the forties (global destruction) following the thirties (global depression).
The Federal Reserve system tried to make itself seem useful in 1947 when its officials threw themselves into an inflation panic (not unlike 1936’s), fearing a rise in interest rates which some feared might test their ceiling(s) as the CPI surged. The New York branch was immediately directed to buy up longer-term Treasuries to head off the onrushing bond rout authorities had convinced themselves was imminent.
Only to then turn around within twelve months, by the end of ’48, and sell back nearly all the bonds FRBNY had just before purchased! Consumer prices tanked instead as did the whole American economy into that late forties recession. The preceding burst hadn’t really been inflation at all, just another supply shock (originating, mostly, from a rapid resurrection of economic life in Europe).
Treasury just wouldn’t need the Fed’s help at any point. The bond market proved quite able (and less prone to the same emotional errors exhibited so frequently by central bankers) so as to distinguish between a huge CPI surge based on other factors from actual inflation which is always and everywhere about money (Friedman).
The US consumer buying binge following North Korea’s invasion would simply offer another test of this highly crucial difference: bond yields neither predict nor depict the CPI, rather they quite accurately forecast and realistically reflect inflation.
There’s a huge difference between those two very divergent outcomes.
Not for those at the Fed. Once again in a panic, with a robust recovery already underway before Korea, and then consumers blitzing stores, monetary policymakers demanded to be freed from Treasury to make and execute an independent monetary policy.
On August 18, 1950, FRBNY President Allan Sproul told the FOMC the time had come to take inflation seriously. Or, apparently, even more seriously than the ill-advised false alarms of ‘47 or ‘36. This time, Sproul said, there was no further point talking it over with anyone at the Treasury Department because any argument presented would always fall on deaf ears.
Everyone there simply demanded blind obedience – regardless of inflationary fears, Treasury had a war (conflict) to finance.
“We [FOMC] have marched up the hill [taken their arguments to Treasury] several times and then marched down again. This time I think we should act on the basis of our unwillingness to continue to supply reserves to the market by supporting the existing rate structure and should advise the Treasury that this is what we intend to do—not seek instructions.”
Mutiny!
In one somewhat childish (what else would anyone reasonably expect from government turf wars?) episode following that August 1950 FOMC threat, Treasury Secretary John Wesley Snyder thought he would preempt any “rebellious” Fed policy change to increase the Discount rate by surreptitiously doubling up a September ’50 bill auction.
Treasury would refund 12-month bills expiring in September and October early, with both rolled into a new 13-month bill priced at the existing short-term pegged price (obliging, Snyder thought, the Fed to stand by it) before any vote on a higher Discount rate (or change in reserves) might take place.
The overriding concern at either end of the debate wasn’t really bills or short-term rates, rather any effect the Discount rate or higher bill yields might transmit to the entire yield curve. As Sproul would say in the first half of June 1950, even before the fighting in Korea would start, “[I]f we are faced with the decision whether to let long-term bonds go below par, I would let them go below par.”
FRBNY’s President was supported by a majority of the Committee, even if Chairman Marriner Eccles was far more politically sensitive, most often urging consultation and caution rather than this more direct confrontation waged via bond market expectations (whether realistic or not). The CPI of the second half of ’50 was his breaking point.
Thus began - the Federal Reserve will tell you - a watershed moment culminating in March 1951 with the Treasury-Federal Reserve Accord establishing, according to popular convention, central bank independence. Monetary policy was freed from Treasury’s financing needs to set its inflation-fighting stance as it saw fit.
The bond market would have to suffer 1950’s inflation, if that’s what it took to get this done.
But, as usual, the Federal Reserve had it all wrong. Long-term Treasury rates had been rising since December 1949 simply because the economy was recovering (remember those GDP rates the first half of 1950). From a deflation-induced low of 2.19%, the long run Treasury rate (the Federal Reserve only published a single homogenized note rate before 1953) reached 2.40% by March 1951’s accord.
From there, with the CPI just then cresting, the same yield would add another…35 bps by the end of 1952, almost two years after. Yes, just 35 bps in twenty-one months! That’s it. The Fed removed any implicit or explicit obligation, leaving yields to float on their own exposed to what central bankers thought was this huge inflation. Nope.
On the contrary, the long run rate would peak at a high of just 3.13% in June 1953 mostly as a matter of government debt factors rather than the economics (meaning money) of inflation. In fact, by the end of ’52, the annual rate for the CPI had plunged to just +0.75%; by June ’53, it was +0.37%.
We are today supposed to believe that it was this independence and independent “hawkish” policy that killed off those almost double-digit CPI rates in 1951, by nothing more than the Discount rate eventually being raised from 1.75% to 2.00%. Or, more in line with current expectations theories, that inflation just magically disappeared due to the economy and markets cowering in fear (Don’t Fight The Fed!) of this mighty monetary giant throwing off the shackles of its Treasury jailor (something like primitive “forward guidance”).
Nonsense. The Treasury market did not collapse into a heap of inflation-tarred worthless paper because the Treasury market, unlike Economists and policymakers, was quite able to distinguish between the monetary economics of inflation and a non-economic supply-imbalance. The latter – without the former – is always going to end up transitory and thus of little need nor reference to bond yields.
This ability to filter one from the other repeated yet again later in the same decade as well as over the next one, the raging sixties, which followed. In anticipation of actual inflation later in the fifties, bond yields did rise: the 5-year UST rate jumped from a low of 1.85% in July ’54 to 4.08% in October ’57. It would take the Federal Reserve more than a year from the bond market’s lows before it would begin to raise its Discount Rate.
But the better example was how bonds priced the Great Inflation. Longer-term Treasury rates, such as the 5-year or 10-year maturities, would bottom out in December 1962 during what would be a half-decade reprieve of low inflation and solid economic growth. Those rising yields, however, like those in the late fifties, had sniffed out a serious change in the monetary condition.
Not only did it pre-price the outbreak of legit inflation which followed by the start of 1966, a real bond rout did develop from July 1965 further anticipating as well as pre-announcing the eventual jump in the CPI over half a year later on.
The difference? Unlike 1950-51, or 1947-48, from 1966 onward it was actual money inflation. Bonds don’t project just any CPI level, they trade – as Irving Fisher demonstrated over a century ago – on growth and inflation expectations. It’s not always inflation in the CPI.
Quite helpfully, then, unlike the Fed the bond market throughout modern history has time and time again proven its ability to sort and then reveal to us which is, and which is not.
As for the Federal Reserve, independence hasn’t served it any difference. Its policy deficit has always been, from its very origin, about money. Those working in it still can’t tell one form from another, repeatedly thinking one thing only for the opposite to happen. When it comes to CPI’s as well as bonds, at the Fed they haven’t and still don’t know which way is up.
