On March 7, global financial markets suffered a "Black Monday". European stock markets fell across the board, with Germany's DAX30 down 3.78%, France down 3.77%, Italy down 4.4%, Britain's FTSE 100 down 1.5%; Asia-Pacific stock markets were not spared, with the Hang Seng down 3.77%, the Nikkei down 2.94%, the Shanghai 2.17%, the Shenzhen Component Down 3.43%, and the ChiNext down 4.3%. At the same time, international oil prices rose sharply again, with Brent crude oil futures surpassing the 2012 peak of $128 and once rushing to nearly $140; the London gold price once stood at $2,000 an ounce.
The war and economic sanctions against Russia are hitting global energy and financial markets. Since the outbreak of the war, money has poured into safe-haven assets, with gold, crude oil and bulk futures soaring, while wheat and grain prices have risen rapidly, while European and Asia-Pacific stocks have generally fallen sharply. This is undoubtedly adding fuel to the fire for the international market, which is already in an energy crisis and an inflation crisis.
This geopolitical crisis has created uncertainty about the fragile post-pandemic recovery of the global economy and posed serious challenges to the monetary policy shift of the Federal Reserve and the European Central Bank.
On March 2, local time, at the U.S. House of Representatives Financial Services Committee, Fed Chairman Jerome Powell said he was ready to announce a rate hike at the March FOMC meeting two weeks later, "I am inclined to support a 25 basis point hike in March." However, Powell acknowledged that the situation in Ukraine and the corresponding sanctions have added "high uncertainty" to the U.S. economic outlook, and "it is unclear how the war factors will affect the outlook for FOMC's interest rate policy."
How did the Russo-Ukrainian War hit the world economy? Will it change the Fed's tightening expectations? This article analyzes the impact of this war on the global economy and the monetary policies of the Federal Reserve and the European Central Bank (the next part of the international order will be introduced later).
This article is logical
A combination of poisons: war and inflation
Collapse Combination: War and Finance
Third, the tragic combination: war and stagflation
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01
Poison Combination: War and Inflation
War and inflation are considered a "combination of poisons".
World War I and the Treaty of Versailles sanctions against Germany crushed the German economic system, and as Keynes expected, there was a historic level of hyperinflation in Germany after the war. Hayek, in Vienna, Austria, was affected, his salary in October 1921 was 5,000 crowns, and in the following year he rose more than 200 salaries to 1 million crowns per month. But the purchasing power of this 1 million Clens is far less than the original 5,000. This war and inflation changed Germany, and this "combination of poisons" ignited Hayek's liberal ideas.
In World War II, the specter of war hung over the Eastern and Western worlds along with the haze of inflation. Mr. Zhang Jiazhang, a Chinese banker, later wrote a book in Australia, InflationAry Spiral, which analyzed the relationship between the War of Resistance Against Japan and hyperinflation.
Then came the Great Stagflation in the United States in the 1970s. Many people now compare the Russo-Ukrainian war with the energy crisis with this great stagflation. Many people believe that the great inflation of the 1970s stemmed from the oil crisis of 1973, which in turn arose from the war, which seems to be a typical "combination of poisons". However, this analysis is not reliable, as we will explain in more detail later.
Recently, the Russo-Ukrainian War broke out, the "poison combination" reappeared, and the international financial market and energy market were fiercely turbulent. On the 24th of the outbreak of the war, the price of Dutch gas futures, the benchmark of the European TTF, soared by 51%, rising from 88 euros / MWh the previous day to 134 euros / MWh. Immediately after, the severe sanctions imposed on Russia by European and American countries, especially the use of "financial nuclear bomb" SWIFT sanctions, once again greatly increased market panic. On March 2, the price of WTI crude oil in the United States has exceeded $110 a barrel. The U.S. government announced the release of 60 million barrels of crude oil in an attempt to curb an excessively rapid rise in oil prices.
The main reasons for the significant effect of the "poison combination" this time are:
The Russo-Ukrainian War is the largest geopolitical war crisis in Europe since World War II, and the world's largest geopolitical crisis since the Cold War, which made Europeans feel a general sense of insecurity and demanded severe sanctions against Russia.
Russia is also the world's second largest crude oil producer, accounting for 11% of the world; the second largest crude oil exporter, accounting for 35% of global exports. Russia is also the world's second largest producer of natural gas and the third largest exporter of natural gas. Although Russia's share of international trade is small, its energy trade is very important, especially for Europe.
Third, the EU's energy is highly dependent on Russia, about 30% of crude oil, about 40% of natural gas from Russia, Nord Stream One is the lifeline of Natural Gas in Germany and Europe.
This time, the United States and Europe kicked some Russian banks out of the Global Bank financial telecommunication Association Payment System (SWIFT), but retained the Federal Savings Bank, the largest bank in Russia, and the "Gas Industry Bank" with the deepest connection to the energy sector. Nord Stream One's operating company also said it would not close the gas pipeline. Even so, the intensity of the war, the level of sanctions, the surge of public opinion, and the geopolitical turmoil have far exceeded market expectations, and international oil and gas prices have risen sharply.
This year, international crude oil and natural gas prices were already at historic highs, and this war has undoubtedly added fuel to the fire, greatly raising production and transportation costs and inflation expectations. At present, it is particularly necessary to pay attention to the rise in international food prices. Rising natural prices have pushed up fertilizer prices for agricultural production. Solid or commercial ammonia is the main active ingredient of agricultural fertilizers, and industrial synthesis of ammonia requires natural gas as an important raw material. In Western Europe, spot prices for ammonia have soared from around $225 a tonne to $700 per tonne from the early days of the pandemic to the present. In China, the price of fertilizers this year is also about 50% higher than in previous years, and urea and compound fertilizers are up 1,000 yuan / ton year-on-year. In sub-Saharan Africa, many farmers are considering stopping buying fertilizer this year as prices have tripled in the past 18 months. According to the project manager of the AfricaFertilizer.org research group, this could lead to a 30 million tonne reduction in cereal production – a disaster for Africa.
It should also be noted that Russia is the world's largest producer of nickel-palladium, an exporter of nitrogen fertilizers, and the largest exporter of wheat and barley; Ukraine is also the "granary" of Europe. According to the U.S. Department of Agriculture, in 2021, Ukraine and Russia will account for 58% of global sunflower oil production and 75% of global exports.
This year, global wheat and staple food prices have risen sharply. The Global Food Price Index rose 1.1 percent in January, near its all-time high in 2011, according to the Food and Agriculture Organization of the United Nations. This war has undoubtedly further pushed up international food prices and may also trigger humanitarian crises in Africa.
Chinese companies have contracted one-tenth of Ukraine's arable land and are about to enter the April-May maize planting season, but the devastation of the war, shortages of agricultural workers and chaos in logistics put the region's harvest at risk. After the outbreak of the war, China increased its purchases of soybeans, corn and wheat in North America to reduce the risk of food supply caused by the Russo-Ukrainian war.
So the war has raised food prices and inflation expectations, while also creating huge problems for the Federal Reserve and the European Central Bank, which are seeking a shift in monetary policy. Will the Fed and the European Central Bank step up interest rate hikes to fight inflation? Or will it cut expectations of rate hikes, or even continue to maintain accommodative policies to deal with the uncertainty caused by the war?
The Fed's monetary policy decisions are based primarily on three objectives: unemployment (full employment), inflation (long-term inflation at 2%), and financial stability (US Treasury yield curve).
The U.S. Department of Labor has just released data showing that the U.S. new non-farm payrolls in February were 678,000 after seasonal adjustment, compared with 481,000 in the previous value, and the market expected 400,000 people; the unemployment rate was 3.8%, the previous value was 4.0%, and the market expected 3.9%. The recovery of the US employment rate remains strong, which has created the conditions for the Fed to raise interest rates. Today, the Fed needs to focus most on inflation and financial stability, especially to assess the impact of the war on inflation and financial security. Since last year, the US CPI has soared, reaching 7.5% in January this year, a 40-year high. This war could further improve the CPI figures of the United States. It is even more pronounced in European markets, where inflation was generally low last year, but eurostat data showed that eurozone inflation reached 5.8% per annum in February, higher than market expectations and hitting record highs for several consecutive months. Among them, the inflation rate in Germany is 5.5%, France is 4.1%, Italy is 6.2%, and Spain is 7.5%, all at a high level. The data showed that eurozone energy prices rose by 31.7% at an annual rate in February, which was the main reason for the increase in inflation in the month.
But does the emergence of a "combination of poison" between war and inflation mean that the Fed and the ECB will raise interest rates substantially?
In fact, a high CPI does not equal inflation. Why?
In general, the overall market price is relatively stable, and there are often two main factors for a sharp rise in commodity price indexes:
One is the monetary factor. It is usually the currency that oversends, stimulating demand, resulting in short supply and rising prices. In addition, the credit of money collapsed, the currency depreciated against all commodities, and in turn, prices rose across the board. This is Friedman's proposition that inflation is a monetary phenomenon, and inflation refers to the depreciation of money, which is only manifested as an increase in prices. Strictly speaking, only price increases caused by monetary factors can be considered inflation.
The second is the supply factor. It is usually natural disasters, plagues, wars and other emergencies that hit the supply, resulting in short supply and rising prices.
Is this an oil crisis or an inflation crisis? According to Friedman's monetarist view, inflation is a monetary phenomenon, a "market failure" caused by a mismatch in monetary policy, and an economic problem in which the market cannot stabilize prices through supply and demand regulation. According to this, the oil supply factor can not be regarded as inflation, but can be regarded as an imbalance between supply and demand caused by exogenous variables - the oil crisis should be solved from external factors, such as ending the war and lifting supply restrictions. Powell also acknowledged that monetary policy has no effect on supply bottlenecks.
The same is the rise in prices, the CPI soared, but this phenomenon does not equal inflation. After the covid-19 pandemic in 2020, the above two factors have emerged, jointly driving the continuous rise of the US CPI. This presents the Fed with a conundrum: How to identify inflation? What are the monetary and supply factors?
Unlike the Bernes presidency of the year, Powell now has a clear understanding of the impact of these two factors on prices and different ways to deal with them. When the supply chain crisis broke out in the United States last year, Powell made it clear that the supply chain crisis caused by the new crown epidemic and national bans was not something that monetary policy could intervene in. Today, Powell is able to clearly recognize that energy shortages caused by war factors cannot be considered inflation, and that monetary policy can do nothing about it. "Textbooks often call on central banks not to react to one-off price increases caused by temporary factors such as natural disasters, but to focus on broader underlying inflationary pressures," he said at the hearing. But it can be tricky for the Fed but now, because inflation in the United States is already high. ”
Therefore, Powell expects to raise interest rates in March, mainly for monetary factors and not to react to the Russo-Ukrainian war. During the pandemic, the Fed's overproduction of money has led to "strong demand that has kept up with production that is experiencing supply constraints", and he hopes to curb demand by raising interest rates in March (25 basis points), while saying that "at all costs to curb inflation". The expectation is 50 basis points, and the other 25 basis points are likely to leave room for war factors. This space is not to raise interest rates due to high energy and prices caused by the war, but to leave some room for preventing financial collapses and recessions that war may trigger.
02
Collapse Combination: War and Finance
War and finance are also famous "collapse combinations".
War, which, in any case, advances technological progress, is a net loss for all of humanity. The war undermined the market risks expected by entrepreneurs, causing enormous uncertainty.
The Russian-Ukrainian war and financial sanctions against Russia triggered a "black swan" effect, the US stock market and European stocks in the Asia-Pacific market have fallen, oil prices and gold prices have soared, and financial turmoil has continued to this day. From March 7 to March 7, Europe suffered a heavy blow, with the German DAX30 index falling more than 15% and the British FTSE 100 index falling by more than 7%; the Asia-Pacific stock market was not spared, the Hang Seng index overshooted 15%, the Shanghai Composite Index die fell 3.4%, the Shenzhen Component Index fell 6.7%; the US stock market fought against the decline, the Nasdaq fell 1%, the Dow Jones fell 1.3%. In addition, the brent crude oil futures price once rushed to nearly $140, and the current price of London gold once stood at $2,000 per ounce. Meanwhile, U.S. bonds have once again become safe havens, with U.S. ten-year Treasury yields falling back to 1.74 from 2.06 before the war.
For now, the Russo-Ukrainian war has had a greater impact on the European market than the American market. The main reason is that the war took place in Europe, triggered a huge geopolitical crisis, and brought pessimistic expectations for Europe's energy, finance and defense. When the war broke out on March 7, the euro fell 4% against the dollar, while the dollar index continued to rise.
Historically, the European war has pushed more money into the U.S. market to buy U.S. stocks and Treasuries. This will undoubtedly strengthen the resilience of US stocks and US debt. Since the outbreak of the Russo-Ukrainian War, in addition to gold, crude oil and bulk futures, US dollar-denominated assets, US bonds and US stocks, including the US dollar, are still the strongest performing assets.
What puzzles many is why Asia-Pacific stock markets are as panicked as European stock markets. This war is mainly a dispute between Europe and the United States and Russia, the Asia-Pacific region involves the least cause and effect, the sense of existence is also the lowest, why has the calm Asia-Pacific stock market not become a safe haven?
This could be the Noah's Ark effect. When the end of the world comes, investors will only run to the highlands in panic and squeeze into Noah's Ark. This Noah's Ark is gold, oil and the dollar, and the Asia-Pacific ship is neglected. This shows that there is still a huge gap between the economic heritage, scientific and technological strength and sovereign credit of the Asia-Pacific region and that of the United States. However, there are also rational choices under the panic. Singaporean diplomats say that "elephants fight, grass suffers," a war that has instead heightened concerns about asia-Pacific geopolitics. Singaporeans call on ASEAN to unite and avoid becoming an agent of future geopolitical conflicts in the Asia-Pacific region.
The two countries whose economies have been devastated are the belligerents Ukraine and Russia. Ukraine's economy has continued to languish for the past three decades, and today its most important industrial states and resource hinterlands, Donetsk, Luhansk and Kharkiv, are all mired in war. If it fails to join the EU, the war could drag Ukraine into a "poverty trap." Russia's economy has collapsed, the ruble has fallen, financial paralysis, foreign capital has withdrawn, foreign trade has been blockaded, assets have been frozen, life is hanging on energy, almost insulated from the international market. Since the beginning of the war, the ruble has depreciated nearly 50% against the DOLLAR. If Russia had not imposed a foreign exchange control order, the actual price of the ruble could be much lower than that. The collapse of the ruble's credit has led to a devaluation of the currency, and there is bound to be high inflation in the country. This is the second case of the monetary phenomenon of inflation mentioned above. Some say that Russia has benefited from rising energy prices, which is very limited and carries great risks. In fact, as early as the Crimean crisis in 2014, Russia's economy was subject to geopolitics, and now the Russian economy has to start with geopolitics, especially economic sanctions, to get out of the crisis. In the future, the impact of a deep recession in Russia on the global economy will not be too large, but in the short term, the surge in energy prices will bring a tsunami-like impact to the international energy and financial markets.
It can be seen from this that the impact of this war on the financial market is manifested in several aspects: first, the war has brought uncertainty, and funds have withdrawn from the stock market to hedge; second, funds have entered the treasury bond market to hedge, while vigorously chasing inflation-avoiding assets such as gold, crude oil and commodities; third, expectations have weakened, investment and confidence have declined, and currency cellars have increased; fourth, economic sanctions have frozen a large amount of cash.
So, in addition to inflation, the Fed needs to carefully assess the financial consequences of the war and economic sanctions. Today, with a huge bubble in financial markets and a large amount of assets allocated to U.S. households in stocks, how much can the Fed accept? This is fraught with uncertainty. Monetary tightening was originally an attempt to contain the bubble, and the result may be a puncture of the bubble. Just as the Fed's rapid interest rate hike in 2004 punctured the housing bubble, triggering the subprime mortgage crisis.
The war has exacerbated financial turmoil, and despite soaring oil prices and high inflation, will the Fed lower the number and intensity of interest rate hikes? Will the ECB press the pause button on rate hikes? For now, the ECB is under greater pressure than the Fed as European stocks are hit harder than U.S. stocks.
For now, Wall Street has also lowered its expectations for the Fed's actions. The latest pricing in the futures market shows that the Fed has raised interest rates this year by only 5 (previously expected 7) of 25 basis points each, and traders have acknowledged that the March rate hike is a nail in the coffin, but also completely ruled out the possibility of a sharp 50 basis point hike. It can be seen that the Fed's interest rate hike in March is mainly aimed at inflation caused by currency over-issuance, and the intensity of interest rate hikes may be weakened and the balance sheet reduction time is lower, in order to leave room for uncertainties such as war, sanctions and supply chain tensions.
Next, the biggest challenge for the Fed and the ECB comes from the uncertainty of the war itself. Next, the Russo-Ukrainian war is unpredictable, and many factors affect the stability of prices and financial markets, which in turn affects the Decision of the Federal Reserve.
Will the war expand and will sanctions increase? If wars expand and sanctions escalate, money will be pumped out of financial markets at an accelerated pace. How should the Fed and the ECB respond to the freezing of large amounts of money and the currency cellar, leading to a short-term "liquidity trap" in the market?
In the European market, russian oligarchs have long played the role of cash traders, and freezing or restricting the flow of hundreds of billions of dollars in Russia is enough to affect spreads and weaken the liquidity of the market. European and American countries have restricted Russia's financial transactions in the European and American markets, and may freeze large amounts of financial capital, including some foreign exchange reserves of the Russian central bank, Russian banks, energy oligarchs and huge cash in the private sector. Russian banks have more than $450 billion in non-gold foreign exchange reserves, and the private sector has more than $500 billion in liquid investment. Zoltan Pozsar, an expert on credit Suisse's repos and currency channels, warned in his latest report: "Western sanctions against Russia could bring a 'Lehman weekend' to the money market. Pozsar believes that the asset freeze and SWIFT sanctions have led to the blockage of payments in the Russian banking system, resulting in Russia's transformation from a surplus agent to a deficit agent, which in turn triggered a chain reaction of debt. Of course, Europe is not one-size-fits-all in its money freeze on Russia, leaving a certain channel for energy and financial transactions. Some Russian banks have been kicked out (SWIFT), but the Russian largest state-owned bank, Russobersbank, and Gazprom, the main channel for Russian energy transactions, have been retained, but will there be an increase in the follow-up?
There are many other uncertainties, such as the issue of energy substitution in Russia. Europe and the United States decided to reduce their dependence on Russia's energy, and Iran and Venezuela may become alternatives. U.S. nuclear deal negotiations with Iran. The United States and Iran are negotiating a nuclear deal that could export oil once it is reached. Last week, as soon as the news of the negotiations came out, the international crude oil price fell sharply in the intraday.
If cooperation agreements are reached and the cost of substitution is reduced, the space for economic sanctions against Russia by European and American countries will increase. U.S. Secretary of State Blinken said on March 6 that the United States is working with European allies to jointly study the possibility of banning the import of Russian oil. This news directly triggered "Black Monday", and international oil and gold prices soared sharply.
The uncertainty of such out-of-market factors is the biggest challenge for monetary decision-making by the Federal Reserve and the European Central Bank.
03
Tragic combination: war and stagflation
If the "combination of poisons" and the "combination of collapse" come at the same time, the global economy will face a tricky situation: stagflation, that is, high inflation, high unemployment, financial collapse and economic depression. This is the tragic combination.
Last year, due to the covid-19 pandemic, energy policy and monetary policy intervention, the Supply Chain Crisis broke out in the United States, prices rose rapidly, and the economy recovered structurally. This year, inflation in the global real economy has been higher, financial market instability has intensified, and the marginal tolerance of companies to rising interest rates and falling liquidity has been very low. The Fed's monetary policy this year has had to be cautious, fearing a run-off between high inflation and high bubbles.
Now, the war has further exacerbated this possibility: runaway inflation and a collapse of the bubble. The Russo-Ukrainian war and economic sanctions pushed the world economy in the direction of stagflation, energy prices pushed up prices, and sanctions exacerbated financial vulnerabilities. A British think tank pointed out that the war in Ukraine could trigger another supply chain crisis, which in turn will lead to a $1 trillion reduction in global gross domestic product and an additional three percentage points for global inflation this year. This is stagflation expectation.
Once the stagflation phenomenon is formed, the monetary policy of the Federal Reserve and the European Central Bank will be constrained and caught in a dilemma: no interest rate hikes, high inflation; interest rate hikes, financial collapse.
Last year, inflation in the eurozone was much lower than in the UNITED States, and the ECB took a dovish stance and was not eager to raise interest rates given the imbalances in the eurozone. However, the situation in Ukraine intensified, eventually rising to the level of war, which greatly pushed up energy prices and price indexes in the euro area this year. The ECB is currently assessing the impact of the war and its evolution on European energy prices and prices, on the one hand, and the extent to which it has "dragged down investment and consumption and hindered economic growth" on the other. Philip Lane, chief economist at the European Central Bank, pointed out that the Russian-Ukrainian conflict could reduce the eurozone's output by 0.3 percentage points to 0.4 percentage points this year. At the same time, the ECB needs to pay more attention to financial vulnerabilities and be able to accept a large drawdown in European stock markets that have fallen into panic. On the third day of the outbreak of the war, Germany made a "historic change" by announcing a massive increase in military spending. However, on that day, german government bonds fell by more than 20 points in a single day for the third time in more than three decades. This shows that european stock and bond markets do not yet have consensus and confidence to deal with this geopolitical crisis.
At present, the ECB and the Federal Reserve must quickly identify two questions: First, is energy and price increases a monetary factor or a war factor? The second is to confirm whether the phenomenon of stagflation is forming or is accelerating?
Adjusting monetary policy without a clear identification of these two issues could be a huge disaster. If the energy and price increases caused by war factors rather than monetary factors are regarded as inflation and then tightening the currency, this is a matter of seeking fish and indiscriminate drugging, which may lead to a deep recession in the economy; if the phenomenon of stagflation is confirmed, and it oscillates between austerity and easing, the economy will be stuck in a quagmire for a long time.
Let me give you an example. In October 1973, when the Fourth Middle East War broke out, OPEC announced that it would raise the price of crude oil from $3.011 a barrel to $10.651. The war led to a surge in international oil prices and a major outbreak of inflation in Europe and the United States. This seems to be a typical combination of war and inflation.
U.S. President Richard Nixon and later President Carter both placed the blame on inflation on the Arabs. Most damningly, Arthur Burns, then chairman of the Federal Reserve and Friedman's mentor, also believed that inflation arose and would end with war. He cites scriptures to explain that monetary policy cannot solve the inflation problems caused by the war. Burns did not tighten the currency vigorously, while he sought to reduce the weight of oil and food prices in the CPI to reduce external pressure.
Is there anything wrong with Burns' judgment? After the war, the mystery was revealed. The war soon ended, crude oil supply gradually recovered, inflation in Japan, Germany and other countries also tended to fall, but the United States is still in the "water". Why? Just as economists were confused, his proud protégé Friedman gave a plausible explanation. In fact, Burns considered the war factor, but ignored the more important monetary factor. Friedman believes that inflation is a monetary phenomenon that arises from the over-issuance of money. In the mid-to-late '60s, the legendary Chairman of the Federal Reserve, Martin, failed to withstand pressure from President Johnson to lower the federal funds rate, and inflation in the United States was as high as 5% in 1968. The next Fed chairman, Burns, lowered the federal funds rate in support of Nixon's re-election. So, given the overproduction of money, the Fed needs to raise interest rates appropriately to curb inflation – this is Friedman's claim.
However, another very important monetary factor that Friedman did not capture, but later the fed's greatest chairman Paul Volcker paid attention to, that is, the collapse of dollar credit. The deeper cause of this great stasis was the collapse of Bretton Woods in 1971.
Why did the Bretton Woods system collapse? Professor Trenifon has long predicted a "paradox" in the system, namely that the United States cannot export dollars while exporting goods. When commodity exports are weakened, the trade deficit increases, the dollar's credit anchor, gold, is also reduced, and when the gold loss reaches a certain threshold, the dollar's credit collapses. This is the Triffin conundrum, the contradiction between the fiat currency system and international trade, which still exists today. However, there was another important factor in the loss of gold in the United States at that time, that is, the Vietnam War. This protracted war (1955-1975) was the most numerous and influential war in the United States after World War II. The United States has gone from being a net creditor to a net debtor due to the attrition of this war. In the 1970s, when sovereign debt was included, the U.S. net gold reserves were negative, triggering a credit crisis in the dollar, with European governments abandoning the dollar and redeeming gold. In 1971, nixon announced the suspension of the gold exchange window for the us dollar after the Camp David Conference, which declared that Bretton Woods was in name only.
Therefore, the cause of the great inflation in the United States in the seventies was ostensibly the oil crisis caused by the war, mainly the depreciation of the US dollar caused by the Fed's over-issuance of currency, and fundamentally the collapse of the Bretton Woods system caused by the Fed's credit crisis. It's still a poisoning combination of war and inflation, but the explanation is quite different: the Vietnam War replaced the Fourth Middle East War, with the collapse of monetary credit triggered by the former replacing the energy price increases triggered by the latter. That was the essential difference, but the Fed chairman at the time failed to identify it.
Why did Volcker recognize it? Because it was Volcker, then deputy secretary of the Treasury, who led the plan to dismantle the Bretton Woods system. Volcker was well versed in American inflation, the collapse of the dollar's credit and the Bretton Woods system that he himself ended.
Throughout the 1970s, the dollar suffered three devaluation crises, and this process was also the process of repricing the dollar. In 1979, Volcker stepped down as Chairman of the Federal Reserve and began a saga of violent resistance to inflation.
However, in the same year, the second world oil crisis broke out. This oil crisis still stems from war. In 1979, the Islamic Revolution broke out in Iran, the Pahlavi dynasty collapsed, Iran stopped oil exports, and the international crude oil market fell into a shortage crisis. In 1980, the Iran-Iraq war broke out and oil prices soared. International oil prices rose from a peak of around $15 a barrel in 1979 to $39 in February 1981.
The second oil crisis brought the United States the worst recession since World War II. In addition to high unemployment and inflation, financial markets have fallen and languished. In October 1979, the Dow Jones index fell -7.16% to only 815 points in the month; until September 1982, it stayed at more than 800 points for a long time, and it should be noted that as early as January 1971, the index still had 868 points. In other words, the U.S. stock market is mired in a deep bear market that has lasted for more than a decade. What should I do then?
Once stagflation is confirmed, how should the Fed operate?
At this point, the only solution is to tighten the currency. Not misled by the second oil crisis, Volcker raised the federal funds rate to 20 percent while buying back dollars in large sums, reducing liquidity in the market. Volker was well aware that all he needed to do was save dollar credit. At this time, the new monetary credit system of the US dollar was basically formed, and its credit anchor was no longer gold, but replaced by US Treasury bonds. In addition, Kissinger's diplomatic achievements have given the dollar an important application scenario, namely oil trading, known as the petrodollar system. In addition, after three depreciations and more than a decade of price rediscovery, the dollar has the equivalent stability, which is worse than the Fed to restart credit.
At this point, economist Mundell and Ratrich of the Reagan administration's Department of Finance and Budget made a quantitative model. The model argues that as long as the Fed reduces the money supply, international capital will re-establish trust in the dollar, abandon anti-inflation products such as oil, and then buy U.S. financial assets, and there will be a "beautiful scenario": "about trillions of dollars of assets will be transferred to the bond, securities and stock markets."
But Volcker's high level of austerity triggered a deep recession in the U.S. economy, widening deficits, rising unemployment, financial turmoil, and he also suffered a storm of criticism. The year 1982 was derided as the "Year of quacks", which is also known as the Walker moment. However, Volcker withstood the pressure, inflation fell in the second half of 1982, the Dow Rose miraculously in October, and the "good scene" deduced by Ratrich emerged...
Fight inflation, protect free prices, and then restart markets. This is the logic of the fight against the stagflation crisis. This is the fed's ingrained experience, and certainly a situation Powell does not want to face.
Powell stressed: "As we learn more about the impact of the Ukraine crisis, we will proceed with caution." The war and sanctions against Russia are also fraught with uncertainty, which is why the Fed and the European Central Bank should be prepared for a combination of poison, collapse and tragedy.