How An Old Banking Regulation May Have Driven The 1970s Inflation

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1:16Hello and welcome to another episode of the Odd Lots podcast. I'm Joe Weisenthal. And I'm Tracy Alloway. 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. Right. So gas prices are starting to creep up again. House prices have been incredibly stable and 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?

1:57And 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. Right. You know, 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, right? This was when you were looking at the mountains and thinking of US CPI charts? Yeah, the Grand Tetons look like the U.S. CPI from 1974 to 1985. But it's true that throughout the 70s, there were multiple times where people sort of breathed a sigh of relief.

2:38They said inflation has been licked, and then it came back. And it's really, you know, there's this story that there was all this irresponsible policy, and then finally Volcker came and smashed inflation. And it really did not exactly happen like that. Right. 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 policymakers and economists and academics kind of came of age in.

3:16And 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. You're absolutely right. And you mentioned that the 1970s looms so large.

3:58Policymakers, 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. Right. So we're always worried about deflation. We're always worried about 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.

4:44Because I don't think that outside of these vague things like, 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 like, yeah, but why was inflation so persistent and so reoccurring throughout, you know, roughly a decade? The ghost of Paul Volcker is going to be so mad at us, but I think we should do this. 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're going to be speaking with Itamar Drexler. He is a professor of finance at the University of Pennsylvania, someone who's done a lot of research on this period and what it means.

5:25Professor Drexler, thank you so much for coming on OddLots. 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. 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, what caused the 1970s inflation? Why did it keep coming back? We mentioned in the beginning, the gas lines and the end of the Vietnam War, and maybe policymakers were not strong enough in fighting it. But what is the macro consensus about what happened in that decade? So I think the most common story narrative is that the Fed, there were at the outset, let's say, some kind of shocks 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.

6:31What that does is raise the real interest rate, thereby lowering demand or what they call demand management and preventing inflation from accommodating inflation by letting it go up. And 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. Right. So the idea is that prices started to rise.

7:07The 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. And then it wasn't until Paul Volcker came in, told everyone whose boss reestablished the Fed's credibility and kind of deflated those inflation expectations that things got better. Right. Yeah. 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 All Thoughts, most notably in our episodes with Josh Younger and Lev Menend, where we were talking about the origins of euro dollars and shadow banks.

7:54But you place it on RegQ. Can you talk a little bit more about that thesis? Yeah, sure. So RegQ does come up a lot. It's a very famous banking regulation. Historically, many banking people and monetary people are well aware of it. So RegQ was a regulation that came out of the 1933 Banking Act that allowed the Fed to place a ceiling on what banks could pay, 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.

8:39So 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. 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 failure.

9:15So they thought, well, we'll put a cap on this and then we'll have healthier competition. Is that right? That's the story that's told. I know 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. Right. Because if you know that you're insured, I could just go out and say, oh, here's 10 % interest rate on your check-in. The Bank of Joe and Tracy will offer 50 % interest on deposits.

9:47I collect all of the deposits from everyone else and maybe I fail because whatever I'm doing with that, but I got all the deposit. I'm in. Let's do it. Yeah. Okay. So I stopped you right up in the late 1960s. So in the late 1960s, they make this change. Yeah. They decide, they, 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.

10:30And so this was used in the UK, famously in France, in Italy, in 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. 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 and research for you?

11:06Yeah, so it's a little bit out of left field for me and my co-authors. I have two very common co-authors that we've worked a ton together at NYU, Alexei Savov and Philip Schnabel. 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 is, 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're 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 70s, the average deposit rate barely reacted at all to the Fed funds rate.

11:56Now, that's not a discovery because I knew about regulation Q. I just had never been in my face that way. And there's a very famous graph coming out of the literature of the standard narrative, Clarida Galley Gertler is the most famous paper with thousands of citations, that is a similar graph, but instead of deposit rates, which they don't consider, they have the Fed funds rate in inflation. And that's the famous graph that shows that before 1982, the Fed funds rate just mostly kind of sticks to inflation, whereas afterwards, 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.

12:32But here we saw that deposit rates are also kind of look like that. I thought the timing was sort of better. And if you think that people's deposits is an important part of their savings, which it is an important 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.

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13:59Introducing the all-new Adobe Acrobat Studio, now with AI-powered PDF spaces. Do more with PDFs than you ever thought possible. Need AI to turn 100 pages of market research into five insights with a click? Do that with Acrobat. Need templates for a sales proposal that'll close that deal? Do that with Acrobat. Need an AI specialist to tailor the tone of your market report to sound real smart in real time? Do that with the all-new Adobe Acrobat Studio. Learn more at adobe.com slash do that with Acrobat. 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 the sort of 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.

14:53If 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 like, okay, 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 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. The way we hear things now, I also had the impression that there was a lot of monetarism at the time.

15:26Looking for it, it's after the fact, not as much of 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 is I think, so there was a lot of, there was it by the end, a lot of looking at growth in the money supply and in trying to keep tamping down growth in this 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.

16:01And I think most of the mainstream macro and monetarism not now, doesn't mean it's wrong, but I think monetarists a little bit don'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. Money pays no interest. And so it's a dominated asset and must have some other use. And as you raise, as you lower the interest rate, you make it more easy for people to have money and they can spend more. So the thing is, it treats each money as just number of dollars.

16:36But what you see in the right queue time is 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 of 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 was more dollars, but the ceiling was not binding.

17:24The 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 queue 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? The idea was that by not letting them pay the interest that they want, some deposits would leave the banks. That was the, in fact, intention. That is what happened. It was called disintermediation. And so deposits would flow out. The idea, I believe, was that this would tampen down demand because credit growth was the source of excess demand.

18:06And 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 was on 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.

18:41And 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, well, you see, this is known, you see both inflation and a decrease in output. it. And then we look across firms and we show that more credit constrained firms raise prices more and cut output more, cut employment more, cut investment more, cut inventories more.

19:20All right. Let's talk about the data that you collected because it's a good story, right? That, okay, 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? 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. Wait, you can't do economics just by like looking at two big charts?

19:52I think you could do that. I've made my whole career on that. 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 it was 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, OK, let's look at something that just compares firms that were more exposed to this problem versus less exposed, holding constant things, you know, that are aggregated.

20:35like 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. 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 versus savings. Right. That was actually the first line of reasoning that we went through.

21:14So 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 so both effects go in the same direction, which I can tell you in a second how that happens. So if you want to if you're thinking about saving and let's say that for you, the marginal saving is deposit, 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, right? It's way below the inflation rate. At times it was seven, eight, 9 % below inflation because the cap was like five, five and a half percent.

21:45Inflation 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. 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.

22:26Rates 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. Yeah, so what macroeconomists think of as 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.

23:00But 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 saver 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 like a classical sign of a problem when you have different prices for the same thing on both sides and it's not coming together. 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 like, 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're inhibiting monetary growth, the growth of money supply.

23:47That was the way that monetarists saw that. And you saw no evidence of that. 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 monetary perspective, each dollar much more money-like. Do you mind having dollars if 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.

24:21It's really bad. You have to sort of think what was the point of monetarism. It's like the nature of the money kind of changes almost. I think it becomes more money. I mean, this is like, they use 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? Surprisingly, I don't think it was that profitable. And it's a good question why. But I think also the rates at which they, 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.

24:56So actually, at the time, people thought that when you get rid of RegQ, it would make the banks very unprofitable. I'll tell you what it did do. It led to the SNL crisis. So I guess I should be kidding. 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. Getting back to your supply side analysis, and you mentioned you sort of tried to go sector by sector, who would be particularly in like, okay, who all things being equal, who is exposed to this sort of severe rationing of credit from the banking system having less money?

25:31What did you find when you look at the sort of sectoral breakdowns, what kind of things pop up? So I should be specific and say that the database we have, because we needed a database of lots of information is the NBR or CES database on manufacturing industries. So already it's all manufacturers. We need the prices they charge and we need stuff on their inputs. And so it's all different kinds of manufacturing. And so 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.

26:10So 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 than which ones were less. But you think that somebody carrying a lot of inventory, a lot of upfront costs would need a lot of credit. And somebody who doesn't, you know, at all, maybe the tobacco manufacturers, it's not as big of a deal. 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.