Former Fed President Warns Easy Money Will Bring Consequences

Mindy:
Welcome to the BiggerPockets Money Podcast show number 281 where we interview Tom Hoenig, former president of the Federal Reserve regional bank in Kansas City and talk about inflation, Federal Reserve policy and potential rising interest rates in the coming months and years. I know it sounds weird but I swear this is a really fun episode.

Tom:
And so you need to have an interest rate that promotes not a boom, not a speculative environment, not zero interest rates, but interest rates that are balanced where I as a saver gets a fair return, not zero, not point two in my bank. I as a saver gets it and as a borrower I can borrow money at a reasonable return so that my investment gives me enough money to pay back my loan and enough to get a return on my capital.

Mindy:
Hello. Hello. Hello. My name is Mindy Jensen and with me as always is my, it’s an art not a science co-host Scott Trench.

Scott:
Thank you as always for painting such a wonderful picture of our podcast become.

Mindy:
Oh, that was good. Scott and I are here to make financial independence less scary, but just for somebody else. To introduce you to every Money Story, because we truly believe financial freedom is attainable for everyone, no matter when or where you’re starting.

Scott:
That’s right. But do you want to retire early and travel the world, go on to make big time investments and assets like real estate, start your own business, or generally understand the rules of money and the economy. We’ll help you reach your financial goals and get money out of the way so you can launch yourself towards those dreams.

Mindy:
Okay, Scott, this episode is so much fun. Tom Hoenig is, like I said before, the former president of the Federal Reserve Bank in Kansas City. He has quite the impressive resume. And I’m so delighted to talk to him today, he is featured in a new book coming out, called the “Lords of Easy Money”, where they talk about the effects of the Federal Reserve policy of the last 10 to 20 years with rates being so low, that they’ve had effects on the price of assets. I am just so delighted to talk to him. He was such an interesting person, and he had so much information. If you are living in America today, you need to listen to this episode.

Scott:
Yeah, I think, Tom is a very special guest for us. And we’re very flattered that he accepted our invitation to come on the BP Money Show Podcast here. Mindy and I actually discovered, not discovered, became aware of who he was and his importance to the economy in a general sense, through an article that someone shared in our Facebook group called “The Feds Doomsday Prophet” as a dire warning about where we’re headed. And so if you will link to that in the show notes here at BiggerPockets.com/moneyshow281, but just thrilled to have had him come on the show. This is a true master of the economy of all things, public financial policy, public policy, broader economic theory, those types of things, and I think was a real privilege to get to interview him today and learn from him.

Mindy:
Yep, I learned a lot from him. And it was just so wonderful to listen to him explain these theories, in ways that are really easy to understand. It really helps see what the thought process was behind the reason for the low interest rates that we’ve enjoyed for so long, and, more importantly, to understand why those needs to go away in order to help the American economy. Tom Hoenig is our guest today, he is the former president of the Federal Reserve regional bank in Kansas City for 20 years. And after stepping down in 2011, he became vice chairman and a member of the Board of Directors for the FDIC where he stayed for six years. He has a PhD in economics. And I think it’s pretty safe to say that he understands money and fed policy and the general economic situation of America. So Tom, welcome to the BiggerPockets Money Podcast. I’m so excited to talk to you today.

Tom:
Thank you for having me, I look forward to the conversation. Hopefully I can contribute.

Mindy:
Oh, I bet you can. You’re very modest. So I gave just the highlights of your career. Let’s go over a little bit of your backstory really quickly before we get into talking about some of the things that you are well known for.

Tom:
Well, you did hit the highlights and I was in the service for a couple years. Came back to the United States in 1970 and then went right into graduate school there and at Iowa State University and I enjoyed it very much and I actually emphasize macroeconomics and monetary money and banking actually, and worked in that field for my PhD dissertation. And then I left there to go to the Federal Reserve Bank of Kansas City and to be an economist in their division of banking supervision and structure it was called. And in that period, worked with commercial banks, supervised some of them, reviewed merger acquisitions and so forth and did that for a while. And then I was… By the time the crisis of the 80s came, I was an officer at the bank and worked through that terrible crisis. It was a collapse in asset values, in agriculture, in commercial real estate, in energy for state of Oklahoma, Wyoming, Colorado, that was terrible.
Commercial real estate was kind of universal problem. It also affected home ownership. So that was a very trying period, I learned a great deal from that, probably more from math, and I did any PhD program in terms of how the economy works and doesn’t work. And I did that until 1991, where they asked me to be president of the bank, I was honored to be selected. And I joined the FOMC at that point, and worked through a good part of what was going on in the 90s. And then, through the crisis of the financial, the Great Recession and the financial crisis of 2008 and 2009, and saw a lot of bruises from all that, but also a lot of learning exercise.

Scott:
You had a first row seat with that job at the Kansas City Fed for the inflation in the 70s and 80s. And without giving too much away, I think a lot of the foundation for that inflation might have been set in the 60s with some Fed policy, could you walk us through your observations as a witness and having that front row seat, and what you think caused the 70s and 80s, high rates of inflation and interest rates?

Tom:
Well, the US economy was, as they entered the 60s, it was in a recession, they eased rates, but the real thing was it was a dominant economy in the world. And in the 60s, it took on more, if you will, programs. Number one, it decided to get involved in a war, the Vietnam War. That was a big spending requirement. It also under President Johnson created the Great Society program, which was a very significant expansion of support for lower income households. And that was a big spending program as well. So you had during that period, a very significant expansion in spending and in borrowing to accommodate that spending. So you had both increasing deficits and the general budget itself increasing, and at the same time, you had in that environment, interest rates would normally rise.
So the political environment was such that there was a lot of pressure put on the Federal Reserve to print money to help finance if you will, the spending increase that was taking on, and when you get that combined, you get large government spending increases in debt, large increases in money. At one point, I think, by the time we got to the early 70s, the money supply of this country was growing at 13% rather than 3 or 4%, it had been from an earlier time. And so you have greater increases in demand, then you have supply with the company deficit, then you get inflation. And inflation was really even in the very earliest part of the 70s, after the 60s had kind of gone its way, you had 8% inflation. And one of the things that happened then, you begin to react to that. And labor starts wanting more because they need to keep up with inflation, and becomes very unsettling. And it was a tough period that we entered even as we began the decade of the 70s.

Scott:
And you had to deal personally with some of the ramifications of that. How did that impact the valuation of assets in addition to labor and your day to day job?

Tom:
Well, what was going on in the 70s, it was really a kind of a mixed bag. The administration and the Federal Reserve, when the inflation got to 8%, the administration put wage and price controls on, made goods even more scarce. And so when they took them off, inflation actually shot up again and the Federal Reserve in trying to fight inflation did try and kind of slow down the growth of its printing and the money. And as the economy began to stall, they would back off from doing that, they would lower rates again because they were more afraid of a recession. So you have this kind of stop goal, but each time you started going again with monetary expansion, inflation got a little bit worse.
And so by the end of the decade, you had very high asset inflation as well as price inflation. Now, as far as the asset inflation goes, banks were very… Hadn’t experienced it like this since before the Great Depression. So they were making loans based on asset values. So agriculture, if you wanted to buy more land, you would borrow knowing that the price of that land would only go up, the banker would feel very comfortable because the price of land was going to go up. So they make a bigger loan secured by that land. You saw the same thing in energy, went from $8 a barrel to $50 a barrel. And they said, well, it’s going to be $100 a barrel. So banks were willing to lend against that on the assumption that their use will only go up and commercial real estate. They saw the increasing value of commercial real estate.
And I can remember bankers saying, well, we’re going to lend 100% on the construction of that new high rise because we know that it’ll be worth 120% of the initial cost by a year very quickly after it’s built. And we’ll still have a very good margin on the loan. And so we’ll make a loan on that. Well, as inflation continued to increase and became price inflation of 13%, when they introduced Paul Volcker, who said, “We’re going to end this price inflation because it’s only going to get worse.” That just crushed the asset markets, it just absolutely stopped him from increasing the value because interest rates were now not 4% or 5%, they were 20%. So commercial real estate dropped, land values, agricultural land values and other land values dropped, oil went back down to $6/$7 a barrel. And you have this enormous implosion that hurt the entire economic system. And it was a very difficult, painful experience for everyone, no one was exempted.

Scott:
Could you give us just a brief anecdote about interaction, interactions you might have had with banks at that point in time?

Tom:
Well, that was terrible, they were failing, because what happened is, when you have a loan, and you can’t cash flow any longer, because prices are falling addressing inflation, and your asset values are collapsing, so you have to charge off those losses. And when you charge off those losses, it’s against your capital that you’ve funded yourself with. And when that runs out and in too many cases it did, there was like 1200 bank failures. There was well over I think 300 in the regions I was responsible for. And so those banks are in communities, some of those banks were fairly large, some were community banks in rural areas, but it just totally disrupts that local economy.
The most famous was in our region, at least and probably one of the most famous in the country, was this so called Penn Square Bank, this is a bank that made literally billions of dollars of energy loads. And this was a bank that was less when it started than a billion dollars, and it was selling these loans to other banks around the country. So when these values collapse, this bank ran out of capital very quickly, losses, and all these loans ahead sold to other banks, Seattle Seafirst was one of them. One in Continental Illinois in Chicago, then those banks also got in trouble.
So you have this chain effect from that major. One category that is energy lending, not agriculture or commercial, it was energy. So now take that Agriculture and expand it, you could see that entire communities were brought to their knees, unemployment rose significantly, it was a very difficult time for everyone. And for us working with bankers, having to shut those banks down is really a difficult moment for everyone in that community as well as for the FDIC who had to close those banks down. It really is heart wrenching to see lives up completely.

Mindy:
So what you’re describing is happening in the 70s and into the 80s. What you’re saying, though, I’m hearing I’m feeling right now, as well. And you kind of predicted this starting in about 2010. With your votes against the quantitative easing. Can we talk about quantitative easing for a little bit?

Tom:
Sure. Quantitative Easing is a concept, it says, the economy was recovering from this very serious crisis. And during the crisis, the central bank and the government put a good deal of money, the Federal Reserve loaned out or provided liquidity in literally trillions of dollars during that period to stop the spread of that crisis from becoming worse. And I actually agreed with doing much of that. But in 2010, the economy was recovering. There were other global issues, but the US economy was recovering. And what happened was, there was a very strong view that unemployment was still too high, it was over 9%, that the recovery wasn’t going fast enough. And that if you then did this quantitative easing, and that is, you bought trillions of dollars of assets, either government securities or mortgage backed securities, and you put new money, called base money into the banking system.
So you would buy these assets from banks, who got them from the government that has securities, and that would increase their accounts, and they could lend them money out and things would be good. But the difficulty with that is you have so much demand in the economy, so much production capacity. And the Federal Reserve had decided to just flood the economy with money. And my concern was that, what you’re going to do in that environment is, you’re going to increase asset values very quickly, that money has to be deployed, you’re going to move, you’re going to lower interest rates to zero, we know the zero interest rates does push up asset values. If you had a government security, and it went from 5% to 1%, the value of that security would go up quite a bit. And so that was the idea to raise the asset values, both short term and long term, and both government type assets but other assets as well. And that’s what it did. It raised assets. But it did so for the stock market which nearly doubled between 2010 and 2015 or 16. It did it for commercial real estate, it did it for agricultural land again.
So you were doing exactly what you did before, you were raising all these asset values. People might feel richer but there’s another side to that. It did not increase productivity in the economy. This money was such an extent of increase in this money and lowered interest rates. It encouraged speculation. It encouraged the fact that you grew the derivatives market multiples of its original size, you increased the spending on speculative investing in various assets, whether it was land or whatever. So you were artificially giving increases in price, but you weren’t investing in new plant equipment to any great extent. You weren’t making the worker more productive. So real wages stagnated. So if you were an asset holder, you were well off, you were kind of a winner. If you’re a wage earner, and you didn’t have enough to get into the stock market or enough to buy a piece of real estate, or even buy a new home because prices of housing were going up so quickly that new entrants had a greater difficulty.
So what you did is, you increase the divide between those who have, the haves, the wealthier group, upper middle class and the very wealthiest. And you didn’t necessarily decrease incomes for the lower class yet because you didn’t have price inflation, but they were falling further and further behind because their incomes weren’t rising to the same extent. So you created this divide that I think people resent it, people saw it, they were not oblivious to it. And you created this artificial game, it was arbitrary, it wasn’t necessarily an increase in production, an improvement in cash flow based on the increase in the production capacity of the asset, whether it was real estate or otherwise. And so you did a lot of damage to the economy.
So now you come forward, we have this terrible pandemic, we saw a decrease in supply to some extent. But even as it comes back, we did increase government spending, we put more money in the hands of people. And the Federal Reserve accommodated that, they printed the money necessary, they bought the new debt, they increased the spending. And so now we have price inflation. But the trouble is, we have price inflation and asset inflation, and real wages are increasing not at all. As inflation is increasing faster than wage inflation, so the wage earners are now actually losing. And I think that’s unfortunate. And one other thing that’s very important to this, we think that fiscal policy can solve the problem. But two things I would tell people in 2008, when the crisis was there, the government’s debt was about $10 trillion. In 2015, the government’s debt was $18 trillion. So the government had been spending money, people were being provided greater transfer payments, greater support by the government.
By the pre-pandemic, just before the pandemic, that government debt was $24 to $25 trillion. And post pandemic it is $30 trillion. So all that debt is out there, and a good part of it is being bought by the Federal Reserve, putting more money into the economy, not increased production, but more money into the economy. So in 2008, the federal reserve balance sheet was less than $1 trillion. By 2015, it was four and a half trillion dollars. So over a century, the Federal Reserve had increased the so called base money, that money it creates, by less than a trillion dollars in the next three to four years, it increased it by another three and a half trillion dollars. And today, the Fed’s balance sheet, not reserves, but its balance sheet that was four and a half trillion is now almost $9 trillion. So we’re inflating the economy to a greater extent. And now that we have price inflation, not just asset inflation, the Fed is under this very strong need I guess I’ll call it, to begin to address the inflation problem. And I worry about what the consequences of that might be for the economy.

Scott:
Going back to very basics for a moment for those listening, can you give us a one-on-one on price and asset inflation, and what the goal of the Fed is and the basic tools that the Fed has to combat those challenges? It’s a broad question, but can we get a one-on-one on this?

Tom:
Sure, okay, inflation can be caused by various things. But fundamentally, if you are producing more money, that is you’re putting more money into the economy, then you have goods in the economy, then people will bid that money for those goods and prices rise. So in asset values, we were providing this money to the banking system, the banking system was lending it to companies. They were lending it to hedge funds. And those hedge funds or those companies were trying to buy more goods or since they may not feel they can get a return on investing plant equipment, they may choose to buy another company. So rather than increase their productive capacity by investing in plant equipment, they’ll just buy other companies and therefore raise the value of those companies or they’ll take that money, they’ll borrow more because interest rates are now zero because you’re putting so much money in the system.
And when you do that, you begin to reconfigure your balance sheet, you use more debt, you buy more Good, you leverage your company for paying out dividends, buying back your stock rather than investing in goods. Now, when you do that to such an extent, and then you have an increase in public debt then used to also buy goods, because the government is buying it or they’re giving it to people to buy. And in the pandemic, a big part of it was given to individuals as they had to deal with this terrible pandemic, unemployment and so forth, that put money in the hands of people, but it didn’t actually increase the amount of goods. In fact, the amount of goods may have been declining because of the reduction in manufacturing and so forth.
So you’re bidding more money for fewer goods, prices go up just like an auction. And therefore, you see prices rising first in asset values over the decade and then in general price level. Now, it’s effect is, if the wage earner isn’t increasing their wages as fast as the inflation is going, you get real incomes declining. And I tell people, if you think about it, who does that affect the most? Who does an increase inflation affect the most? The wage earner, because people have assets, their values are going up or so at least for the time being, or they have higher incomes, they can withstand the higher price. So it’s a tax. Inflation is a tax and it’s a regressive tax, it taxes everyone poor and rich but its impact on the middle and lower income is greater than the impact on the higher. So you further divide the country between the haves and the have nots. And those are the very negative consequences.

Scott:
In your opinion, what does good look like from a Fed standpoint?

Tom:
Well, the mission of the Federal Reserve and you asked me this is that you want to promote stable long term growth and stable prices, and strong employment. So it has this very complicated multi-mission assignment. And so what looks good to the Fed is low inflation both asset, in some people’s minds, just a price inflation. Low price inflation and low employment. To me a more important goal is low inflation period, low asset inflation, low price inflation, stable income. And real income is rising as productivity in the economy increases. And that’s only possible as investment increases in the economy over time. And so you need to have an interest rate that promotes not a boom, not a speculative environment, not zero interest rates, but interest rates that are balanced where I as a saver gets a fair return, not zero, not point two into my bank. I as a saver gets it, as a borrower I can borrow money at a reasonable return so that my investment gives me enough money to pay back my loan and enough to get a return on my capital.
So that would be the ideal for the Federal Reserve. But the problem is, you also want to have low employment and trying to balance those can get difficult, because if unemployment starts to rise, there’s a strong pressure on the Federal Reserve to lower interest rates to get things moving again. You can do that a little bit, but if you do it too much which often happens, then you get inflation. If you do it too little or you tighten down too much, then you get higher unemployment. So it’s this very difficult balancing act. One thing that I’ve said and I think others have said in the long run, low inflation, moderate interest rates and low unemployment are supportive of one another. But in the short run, they can conflict and that’s where the difficulty of the Federal Reserve making the right decision comes into play.

Scott:
I love that, that’s a phenomenal analysis and makes a lot of things very clear in my mind about what’s going on here with this. So we’re fast forward in here, you become the president of Kansas City’s branch of the Federal Reserve in 1991, and in 2008, we have the recession and you’re aligned with Fed policy of quantitative easing, it’s a tool in the arsenal and you think it’s used appropriately at that point. What shifts in 2010 and you just gave us the overview of the overall economy and the expansion of that balance sheet and the national debt. What are we setting the stage for here?

Tom:
Well, let me clarify in 2008, yes, lots of liquidity was put in. The theory in my mind of central banking is you do provide the liquidity. Because the idea is you provide loans or liquidity to the banks who are solvent, who are able to survive after the crisis once the markets begin to trade again. So the central bank’s role is to provide that liquidity and then back off and let the banks in the market operate. And so you pull that back out, not shock it out, but you pull it back out systematically. So here we are, we got through the crisis, the low point I would call is in the spring of 2009. Of the third quarter 2009, we started recovery, we get into 2010. The world is struggling to recover, but it’s recovering, it is recovering. So you come to 2010, and I did not at all argue at the time to dramatically raise interest rates.
But what was put forward was, we need to bring another version of quantitative easing forward to bring more money into the economy, to speed the recovery, to lower interest rates to zero, to actually deliberately raise asset values so we increase wealth. And by increasing wealth, these people will spend more money and that will help stimulate the economy. And my concern was, from the beginning, that when you are recovering you want to bring things back into equilibrium. That is, you want an interest rate where the saver gets a fair return, not zero. I mean, what good gets traded successfully, if you don’t have a price on it. That it’s free? Well, the market doesn’t last very long, people will stop supplying it. But here you have zero but there is no one stopping the supply, because the Feds are going to do that. But the thing about it is that drives all these returns, which again, drives it down towards zero. And therefore it encourages not just spending for goods and services, but it increases the amount of money you have for anything that appeals to you.
And when it’s zero and you can get more by, you can get show a greater return on your equity by borrowing at zero and paying back your equity holders who want a higher return and buying their stock back, or you buy at zero and buy other companies and consolidate and your capacity. While you’ll do that rather than invest, improve productivity. And when you look at that period, that’s exactly what happened. We raised asset values, but the real wages didn’t increase. Productivity didn’t increase very much at all. It was half as much as it was during the period of the 90s after that recession.
And so we were pumping money in but we weren’t actually improving the economic well being of a good part of the United States population. We were making some people asset wise, very wealthy, we were in creating and extending the divide, but we weren’t increasing productivity and the real wealth of the whole nation. So when this started, having been through the 70s, having seen what they’re, having studied economics and having studied monetary economics, my concern was that we would increase asset values, we would worsen the divide, we would miss allocate resources, which we did, and that the outcome in the long run would be a poor nation. And that’s what I fear has resulted.

Mindy:
It’s kind of hard to argue with you because as I’m hearing you say all of these things, I’m like, “Yes. Yes. Yes. Yes.” I mean, how long have we had these super low interest rates and how much has all of these assets, how much have they increased? It goes back even farther than 2008 and 2010. It goes back to September 11, 2001. Very soon after we dropped interest rates, because of that horrible catastrophic thing. And maybe until like, 2005, 2006 they got up. I mean, high is in air quotes, because a lot of the people who are listening aren’t old enough to remember that interest rates used to be in the double digits and you used to pay 7% as like a real interest rate. And they got into the four or five, 6% in 2005,2006. And now, since then it’s been I mean, my mortgage is I think 2.75%. And my bank account is point 00001%. I love your idea of paying me for my savings rates, because that’s fantastic.

Tom:
Right. And the value of your home was probably gone up quite a bit at-

Mindy:
It sure has.

Tom:
You’re right. Even before 2008… I mean, part of the reason we had the crisis of 2008 was having very low interest rates prior to that. But so the argument back is number one, harmonic. We didn’t have price inflation for most of the decade 2010 to 2020. And that’s all we focus on, price inflation. And therefore, you were wrong. And my argument is, well, I always argued that the inflation would come later, I didn’t think it would take 10 years, but it would come later. But the asset value issue was immediate, and was taking place, and the speculative thrust was taking place just as it had before. And so we were kind of talking past one another. I’m talking inflation broadly, both asset and price. People say that Paul Volcker said that asset inflation price inflation were first cousins. Well, I think that the same darn thing just expressed in a different way. And I think that’s unfortunate that we focused only on price inflation.
And I think I read the minutes of the Federal Open Market Committee after I left the Fed, and they were often expressed that we weren’t meeting our 2% inflation target. So in I think 2012 or 2013, the Federal Reserve, like other central banks said we want we’re going to focus on price inflation and that is going to be 2%. So we want to make sure that inflation stays right around 2%, for a host of reasons. And during this period, inflation was about 1.8%. And there was a great deal of discussion, we’re not meeting our goal, even though as inflation was continuing to rise. My point was two 10% difference in price inflation, that’s not the issue. The issue is asset inflation. So it’s how you, if you will, frame the question will dictate to some extent the answer you will accept.

Mindy:
So looking forward, now that we’ve looked back, and we’ve had basically 20 years of really low interest rates, what do you think is going to happen over the next few years, the next couple of decades at kind of a high level? We’ve got to fix this. We’re in a crunch. So how can we fix this, and what do you think is going to happen?

Tom:
The first thing I tell people is there’s no simple solution, and here’s how to think about it. We’ve set our economic system in the US, and actually globally, around a market equilibrium, interest rate level of close to zero. So you have this entire system, this network functioning around a basic rate of zero, and then a yield curve that goes up very slowly or is flat. So you want to move this from an environment where you have zero rates. And now that you’re being pressed with price inflation as it becomes more urgent, but you have to change that equilibrium to a new equilibrium. Well, it took us how long to get to where we are? It’s going to take us a while, but it’s not painless. Interest rates will have to rise. We have to get our economy back on a equilibrium where you have savers and borrowers, shall we say, imbalanced rather than one subsidizing the other.
And I think that’s what’s going to take place, and it’s going to take a while to do. If you try and do it all once… And I wish we could get it back on once. But if you do that you’re going to shock this economy into a major recession all over again. But the hard part is I think, and this my opinion only, you will have to raise rates. The Fed realizes that. Right now they’re still expanding, they’re still in a money ease situation, they’re still highly accommodated, they’re still buying more government debt every month, they’ll do that till March. Then the question will be, do they raise interest rates, and there’s a lot of discussion. And they will have to raise interest rates, they know that, the world knows that. I don’t know how many times but I do know that even if they raise the rates three or four times at a quarter point, that’ll raise the policy rate from about 25 basis points or over a quarter of a point, to one and a quarter percent, or 120.
That’s still very dominated policy, one and a quarter percent. So that’s the process. So they are going to have to raise rates, they are going to have to raise them probably at least that quickly. And then they need to communicate with the public and say, “Here’s what we’re going to do and then we’re going to wait.” Because effective interest rates isn’t immediate, it takes time. And one of the other errors that sometimes happens in central banks is that they get impatient. So they want to get inflation down, they want to get it taken care of. And then it doesn’t happen when they reach 2%, or two and a quarter percent. So they keep raising rates. And when they do that, they overshoot. So if they get to 2%, they need to wait and let it catch up. But what also happens, and this is the hardest part of all, let’s say they get to one and a quarter, or one and a half percent, or even 2% interest rate, and the economy starts to slow. Unemployment starts to rise from 3.9% to four and a half percent. There will be an enormous amount of pressure placed on the central bank to reverse this policy to stop increasing interest rates.
That’s what happened in the 70s. So then they would back off from it, the economy would pick up, it would improve, but inflation would immediately shoot back up, and then they tighten up again. And then the economy… The inflation was starting to get under control. And then unemployment would start to rise. And there would be enormous amount of pressure put on, and the Fed would immediately back off. And then they would have inflation rise, but even more than last time. And that happens through the 70s until 1979 when inflation was at 14%. So then what happened? Well, now you’re really in a very chaotic situation, a very stressful situation, when people are falling further and further behind. There’s unrest, there’s financial and then even political instability.
So then, Paul Volcker comes in, says, “We’re going to beat this inflation. It’s going to happen. It’s going to be painful.” And he raises rates, he slows the money growth, should I say, stops buying government debt until rates are 20%. People are really hurting. And this lasts for a couple years. And then finally, inflation is brought back down, we can begin to grow again. And interest rates are at a more, what we like to refer to as normal level, where its savers and investors are in balance with one another. And so the toughest part for the Federal Reserve over the next five years, or eight years will be to keep rates not so tight that we strangle the economy, but that we slow the growth in demand relative to supply. So that supply catches up, and demand slows down to where they’re back in balance. And we have both assets, price stability, and price stability. But it won’t come easy. It won’t come quickly, and it will have some pain to it.
And that’s where I think informing the public that we’ll have this is the best that they can hope to do because people will not be satisfied with that. You will see a lot of call for more government spending. And therein lies a very difficult time because when the government starts to borrow more, as it will, then you begin to crowd out the private sector. And interest rates should rise even more, which puts even more pressure on the central bank to buy that debt. Basically help them print the money. And that means inflation will come back again. So it’s such a delicate matter. And I think the Fed is far enough behind the curve now that they’re going to have to be steadfast, not choke the economy to death but steadfast on slowing its growth, slowing the growth in the demand for goods so that the supply I can catch up. And that will be the FOMC’s major challenge over the next half decade or more.

Scott:
So what I’m hearing is we’re in for a period, at some point we’re going to have to go in for a period of long term rising interest rates that are going to come with pain in terms of substantially reduced returns on investments for a number of asset classes, including commercial real estate, maybe energy prices of others might be different things from the 70s their business and stock valuations, yadda, yadda. And that might come with rising unemployment for a period of time, there might be a new normal of higher unemployment and higher inflation for a long period of time to get this back under control. And that the best thing that the Fed can do is say, “Yes, that’s what you’re in for guys. And we’re going to hold steadfast to that, and it’ll take us 10 or 15 years, or however long it takes to get us into a comfortable spot there.” But that’s what I’m hearing you say as the solution to the current situation that we’re in.

Tom:
No, hopefully not 10 or 15 years. Hopefully, a lot less than that. If people become convinced they are going to do this. And you said, higher interest rates. And hopefully, you’ll see inflation come down steadily, maybe even sharply, depending on how convinced people are that the Fed is going to stick to their guns. But hopefully you want inflation to come down, and you’d like to see that happen in three to four years, if not sooner. But the danger is, if you don’t stick with it and you and you back off and you start printing money again, then inflation will pick back up. And then you have to do it all over again. That’s what happened in the 70s. And so what they need to do is make it clear, we’re not going to strangle you. Yes, rates are going to be higher, but zero is not an equilibrium rate, it’s an unstable rate. So we’re going to bring it up carefully. And we are going to see inflation back down to 2%.
That’s our goal. And we’re going to keep interest rates tight enough, not so tight we strangle, but tight enough to do that, whatever that number is, and we’re watching carefully. And hopefully in the next two to three to four years, inflation will come back down to two. Now the Fed thinks it’ll be next year. I think that’s very… I think that’s unlikely. But it could come down over three or four years, if they stick to the guns, and people believe them and they know they have their best interest. Now unemployment will go up somewhat, I suspect, but hopefully not so much that we have an unstable environment. So that’s really the goal that I think I would have, and I hope it’ll go like that. Maybe their better… Their technicians are better that they can get a path that’s easier, but I doubt it.

Scott:
As an investor, we talk about this concept called the 4% rule that says, “Hey, if I build a portfolio and have a big stock bond portfolio, that if I get to about 25 times my spending, or withdraw with just 4% of that portfolio per year, I should be able, I can call myself retired.” That portfolio is very rarely likely to result in the case I’m going to run out of money. Some exceptions to that rule include 1929, with the Great Depression, and then 1965 and 1966, the years immediately preceding the period of high inflation and rising interest rates that we just talked about here. Should investors or retirees be worried, given the prognosis that you just described, about their portfolios? And if so, what are some things that you would be thinking about for those investors who are looking to make sure that their money lasts?

Tom:
Well, that’s a hard question to answer. Because, obviously, if you think inflation is going to continue then you want to leave it in an asset whose value increases with inflation. And your challenge is to be confident that interest rates aren’t going to go up so sharply that you cause asset values to decline or that even if they decline, but over time they rebuild, you might be okay with that. Because there’s no easy answer to that, but you want something that generates income. And that would be, shall we say, inflation sensitive so that your spending power, your real spending power isn’t compromised, and that’s something for portfolio advisors, I think to consider.
My concern is if you’re in a fixed income environment, and you have assets that don’t generate revenues that are, shall we say, tied to inflation, where you’re on a fixed pension which even so security today is indexed, but if you’re on a fixed pension, then your purchasing power will go away very quickly. And that’s what I would be concerned about if I were getting ready to retire and so forth. But other than that, the only advice I can give is, you have to have an asset that generates a revenue that is sensitive to inflation and increases with inflation, and would recover if there is an asset shock. In other words, interest rates rise more quickly than you expected, that while that asset dropped for the time being, they will recover with the recovery of the economy down the road. And so that’s really the only choices you have at this point.
And if you look at the past, even in the shock period of the 80s where we had inflation of 14%, and interest rates was 20%, and the economy did go down over time, assets that generated income did come back. And that’s really you have to be thinking of the long run. Now, whatever your long run is. If you’re 75 or 80 years old, well, your long run is a little shorter than that recovery might allow for. So that’s all the difference. And you want to be in an asset that doesn’t decline in value as quickly whether it’s some form of very short government securities which you won’t lose quite as much value on. Those are choices that people have to make as they anticipate the future, which is unknowable. That’s the unfortunate part.

Scott:
I have another question on this front. From a retirement planning perspective, for the last 50 years, rates have been generally declining, right? Over that period of time. And in a period where rates are declining if you lend, that’s very good. Your equity value, your bond portfolio shoots up. And that’s been happening in this entire period. And retirement planning hasn’t been around that much longer than those 50 years in a truly meaningful sense. So, I love what you’re saying there about how you need something that’s tied to inflation. That means having a lot of bonds in your portfolio seems like a bad bet, if you think that inflation is going to increase or that rates are going to increase over time and in a general sense.
But it’s just that hard question that people are asking themselves if everything you’re saying makes common sense. But if I don’t like bonds, and stock values are overpriced because of low interest rates, and real estate asset prices are really high because of low interest rates and I don’t like Bitcoin. Where do I go for that yield? And it sounds like you don’t have that answer either other than tie it to something that is going to increase with inflation, perhaps like real estate. If you can separate out the asset value, the income stream from real estate investment, it might be protected over a long period of time, for example.

Tom:
That’s exactly right. I mean, that’s my point. I mean, we’re in a difficult situation. We’ve carried on this program for over a decade. Every slowdown is met with a new, larger amount of quantitative easing. We’ve distorted the market. And so I don’t have a solution that saves everyone. And I don’t think the Federal Reserve does either. What I worry about, and this is the hard part thinking ahead, do I have confidence that the Federal Reserve will pick a path of bringing this back into a 2% inflation environment? Will it be able to withstand the pressure? Should, not necessarily it must, but should unemployment starts to rise, and there’s a good chance it will, will they stick to it until they get the inflation brought back? And will they also stick to it to make sure asset price inflation is stabilized?
So that you don’t have this increasing divide between the haves and have nots. And if you have confidence they will do that then you can whether this, most of us can, whether this and get it back to a decent equilibrium. If however they… And they will be because people don’t think about it in terms of the long run. They’re losing money. They’re unemployed. I understand that completely, scares me to death. But if they then say, “Well, no, no. We’ll print this money.” Then we have even higher inflation, people fall further behind and you create this instability, then I think the outcomes long term, even intermediate term, are worse. So it’s a huge challenge. It’s a huge challenge for this country. And I just don’t see a simple solution. Maybe there’s one out there, but I haven’t seen it in all my years.

Mindy:
You’ve mentioned unemployment rising a couple of times. And you quoted, I think, 3.9%, is that would it currently is?

Tom:
Yes.

Mindy:
What’s a good unemployment rate? Or what’s more of an equilibrium unemployment rate?

Tom:
Well, that’s a very fair question. It’s an estimate. What’s the right, zero? Well, people changing jobs all the time. It used to be four and a half percent was thought to be about right. That seemed to have the mix in the market and enough for the economy to be able to function well. People would lose their job, but they’d get rehired. So yeah, I think… But some people think 3.9 is the right number, and that’s part of the problem. Is it the right number? Well, I don’t know. But not knowing allows for you to say it should be 3.5 or 4.5. And so what happens though when people become unemployed, it becomes a major issue in this country. I think if it stayed around 3.9 or four people would be very satisfied with that. I don’t say that knowing everyone’s situation. But if it gets to 5%, five and a half percent, then people will become very, very uncomfortable with it. The politicians will for sure. I think different interest groups will become less sanguine with it. And so they’ll start building pressure on Congress who will build pressure on the Federal Reserve. And the Federal Reserve was designed to be semi-independent, so they can withstand that pressure.
But if you’re the Chairman of the Federal Reserve, or you’re an Open Market Committee member, and you’re getting the tears, if you will, from people who’ve been in unemployment, it’s pretty hard to resist that kind of pressure. But if you don’t, in the long run they’ll be more unemployed. Because, if inflation gets to… It’s 7%, now, it should come down if they follow a good path to get stayed 9%, I can assure you that in time, unemployment will rise as well. Because high inflation creates uncertainty, uncertainty creates a holding back of investment, a holding back of building and investing. And that creates unemployment too. So it’s not necessarily one or the other, you have to get the economy back in equilibrium with the interest rates that allow you to have growth without inflation, and allow the unemployment rate to stay at a reasonable level, which probably is four and a half, maybe 5%. And be willing to live with that. It’s that hard.

Scott:
What I’m hearing is it’s an art, not necessarily a science and a lot of these different types of things. And that’s why it’s so debatable with all these things. What is the right interest rate for that equilibrium? Well, we don’t know. Maybe it’s 2%. Maybe it’s 4%. Maybe three? I don’t know. But then what’s the right level of appreciation? It sounds like, in your opinion, a huge, a subtle but very powerful manoeuvre we could do to get that right might be something like an index instead of the CPI, something that combine that with asset prices of major asset classes or something like that. And then the same deal has to do with unemployment with this and it’s making-

Tom:
Once you do indexing, then that affects the distribution. What you want to do is have them… Frankly, if I were able to choose, I’d have inflation less than 2%. Because that over a generation has a big effect. But if you got it to 2%… People know that 2% unemployment is going to be impossible to maintain. Most people agree to that. So that where the debate comes is between, say three and a half, actually 4% and 5% or 4% and five and a half percent. Most people agree 8% is too high in unemployment. And most people agree the 2% is too low. Most people grieve in 7% or 6%. So you get an area where you can live with it.
And then inflation, 2% is about where you want to be. I would prefer less, others prefer more. So 2% is about right. And that at least allows for certainty. It allows for confidence, it allows for innovation, and the real building of wealth. And this is a critical point, the real building of wealth is not in printing money. It’s not in the government just spending for spending sake. It’s in efforts that improve productivity. So investment in plant and equipment, or maybe infrastructure, because it improves how goods move and so forth. So if you focus on what improves productivity and you focus on assuring price stability that allows for unemployment to remain around 4%, or four and a half percent. Then you have an environment that is stable and in the long run prosperous, and everyone gains. Not just some who happened to hold the assets, but people across the spectrum. And that’s the goal.

Scott:
And that’s hard work, right?

Tom:
That’s hard work.

Scott:
And so the Fed policy has to encourage that and not say, “Oh, great. Instead of having to do all that work, here’s money for free. Buy a bunch of businesses, aggregate them together or let the scale multiply your equity hold-”

Tom:
And speculate away. And I think the federal reserve… I don’t say that anyone I work with, I had bad intentions. I mean, they’re always intended to help the economy improve. It’s how you judge the consequences where the differences come. My judgment was the consequence over the long time would be counterproductive. Others thought it would be pro-productive. So that’s where the differences come. So the goals are the same. And you say it’s art. Well, one of the difficulties is that economists think they’re scientists, they build these complex models, just fine to check with, but it is a matter of judgment of balancing it. You can use the models, you can use the past experience, you can model it. But when it comes down to it, it is an art. It is applying the right amount of pressure, or releasing the right amount of pressure at the right time to allow this economy to prosper. And that’s really what it’s all about.

Scott:
Well, this is this has been fascinating for me. I learned a tremendous amount here with this. And if I walk away with one thing, it’s that art versus science from the Fed. I think that that’s the biggest takeaway, and what should the long term objectives be. And I think a lot of people are going to come away a lot more informed about this stuff and have some good perspective cautioning them.

Tom:
I hope so. I hope they’re able to have the patience because it’s really important for the public to have the patience to get through this. Not just the Federal Reserve. It has to be the public. The Federal Reserve has to be able to stay the course. But the public has to be willing to a point, support that effort. And hopefully, that’s what they’ll do.

Scott:
Awesome. Anything else you’d like to share with us before we conclude here?

Tom:
I probably talked more than I should have already so I’m good.

Scott:
I think we could listen to you all day. And this has been fascinating and a privilege. Thank you very much for sharing all of this and we appreciate it.

Tom:
It was my pleasure, all the way. Thank you.

Mindy:
Yes, Tom. Thank you. You’re welcome to stay for hours. This was a lot of fun.

Tom:
Well, thank you.

Mindy:
I really appreciate your time today.

Tom:
Sure. Sure.

Mindy:
Okay, we’ll talk to you soon. Scott, that was so much fun. I’m so delighted that we were able to talk to Tom, he was such an interesting person. What did you think of the show?

Scott:
I loved it. In another life, I would love to have had a career like Tom’s. Just seems like such a fun, not a fun, but like how to impact the society at a large scale, how to learn the ins and outs of what these things mean. What a guy to be the lone individual, at least within the votes that he was a part of voting no against certain things because of the strength of his convictions with that. So really a lot of admiration for him in his career.
And then just learned a lot today about this. The frameworks around what is inflation? Well, inflation is the increase in the price of goods and services and assets. And they’re maybe first cousins but maybe really the same thing with this and how does Fed policy contribute to income inequality in this country or wealth inequality? I mean, just so many frameworks that tie together the decisions that are being made at the highest levels in our government, and what impact that has on ordinary folks like us.
And the prices and retirement theory in general. Another thing that we chatted about very briefly, and I’ll say this, there’s nothing that Tom observed here, but I… When the pandemic struck… I’m a rental property owner, and we… The stimulus checks go out, unemployment is distributed $600 per week for the first part of that summer, then $300 a week for a very long time following that, and great. So I did not receive a stimulus check. My income was above the threshold there, I’m very fortunate with that. But my tenants all did. And so in one way you could think, and they use that or a portion of those proceeds to pay the rent to me as the landlord and property owner. And interest rates came crashing down. And so my property portfolio, you could argue, was in some parts heavily subsidized if not nearly guaranteed by unemployment and other government handouts. And the interest rates were very low, which increased, which I think was a big factor in seeing some of that 20% price appreciation that we saw nationwide in 2021.
So, you could argue that I’m hundreds of thousands of dollars richer, and have an even more stable source of rental income as a result of that policy, while my tenants who directly received the cash, arguably aren’t that much better off than they were in the first place. And that doesn’t make sense, from a policy standpoint, right? You have to think regardless of your politics, that’s going to be a tough one to… That can’t be the intent of the policy is to put hundreds of thousands of dollars into the property owners pocket and give it… Essentially have the folks at the bottom know better off. So some of the noodle on there and think about, and I’ll be really interested to see how the Fed does handle things on a go forward basis, and how public opinion and public policy is handled over the next several years. We’ve got some interesting challenges in store.

Mindy:
That’s an interesting point, Scott, you said, I don’t think that was the intent of the policy. And it seems like a lot of what they intend doesn’t actually happen in real life. So perhaps the Fed needs to start thinking about different ways that their policies can be interpreted and I don’t know, narrow down, really focus on what you want to have happen, and what is the best way to get this results? And if that’s by raising interest rates, then let’s raise interest rates. And what are all the things that could happen when we raise the interest rates? And like Tom said, let’s educate the American people and let them know what is going to happen down the road? It seems like we’re in for some tough times, and not telling people about these tough times that are coming down the road doesn’t make them any less tough.

Scott:
Yes. But my biggest takeaway is one day, hopefully sooner rather than later before the damage gets even more painful, we’re going to get a moderately tough minded Fed here that’s going to have to make some tougher decisions than they’ve made in the past, because they can’t continue the party forever. And we as a public need to be receptive or supportive of letting that person push that through, within certain limits. And there’s a reason why it’s a separate entity from the federal government and there’s that division of powers there. But I think that’s my biggest takeaway. Is we’re in for that, at some point. Somebody is going to have to do that. And they’ve got to be a tough enough individual or tough enough set of leaders to go and carry that out through thick and thin.

Mindy:
I hope it comes soon so that we can get back to the equilibrium that Tom was talking about.

Scott:
Absolutely.

Mindy:
Okay Scott, should we get out of here?

Scott:
Let’s do it.

Mindy:
From episode 281 of the BiggerPockets Money Podcast. He is Scott Trench, and I am Mindy Jensen saying fly high eagles.