Federal Reserve’s Repeat of 1920−1931 Policy Mistakes Set Stage for Next U.S. Great Depression

The Fed’s Four Discount Rate Policy Mistakes

Mistake 1: Rate hikes transform recession into First Great Depression (1920–1921)

Mistake 2: 1926−1928 Rate hikes created 1929 stock market bubble and depressed home prices

Mistake 3: August and September 1929 rate hikes guaranteed a depression

Mistake 4: 1931 to 1933 deflationary rate hikes extend the duration of the Second Great Depression (1929 to 1938)

The Fed was established by U.S. President Woodrow Wilson in December 1913 to primarily tame the extremely volatile Consumer Price Index (CPI). The chart below depicts the periods of inflation (gold bands) which were followed by periods of deflation (pink bands from 1881-1913. This 32 years was the most volatile period for the U.S. Consumer Price Index (CPI). Gold bands in the chart below represent periods of inflation and pink bands represent periods of deflation. The minimum and maximum inflation for the periods ranged from 6.3% to 23.7%. Minimum and maximum deflation ranged from 6.5% to 15.85% for the periods of deflation which followed the periods of inflation.

The chart below includes the S&P 500 monthly from 1881 to 1913. The index’s average gain per annum for the 32 years was 0.70%

The table below depicts inflation’s peaks prior to the establishment of the Federal Reserve, and evidences a minimum of 10 consecutive months of inflation from 1872 to 1911. A great 15-month example of pre-Fed CPI volatility is highlighted in the table from June of 1882 to August of 1883. Inflation peaked at 11.0% and was followed by deflation peaking at –11.71%.

The chart below depicts U.S. recessions from 1871 to 1913. Volatility of the U.S. CPI from its inception in 1871 wreaked havoc on the U.S. economy during the late 19th and early 20th centuries.

Since its inception in 1914 the Fed’s favorite inflation-fighting weapon has been to raise its discount rate to induce a recession. The chart below depicts the Fed’s discount rates and recessions (depicted by grey shaded areas). The Fed’s discount-rate increases implemented for the purpose of inducing recessions from 1914 to 1952 are represented in the chart below (depicted by the purple dots). Between 1914 and 1952 only two recessions were not induced by the Federal Reserve (depicted by brown dots in the chart).

The chart below depicts that Fed discount rate hikes preceded all of the U.S. recessions (grey shaded areas) from 1950 to 2022.

In the 1914–1952 chart below, the red areas above the axis depict the periods of inflation, which the Fed fought by raising its discount rate to induce recessions.

Mistake 1: Rate hikes transform recession into First Great Depression (1920–1921)

From 1916 to 1919, inflation had remained at a double-digit pace. The chart below depicts that with inflation at 13.13% in October 1919, the Fed raised the discount rate to its highest level since 1915. The strategy was successful. Inflation, after peaking at 23.67% in June of 1920, quickly reversed to a –15.79% and deflation by June 1921.

However, there were consequences. The chart above depicts that the FED had continued to increase the discount rate after the recession had begun. The central bank then steadily raised its discount rate to a peak of 7.0% by June 1920. The hiking of the rate after the U.S. economy had begun to contract transformed the recession into the First U.S. Depression. The chart below depicts the transformation of the recession (grey shaded area) which began in January 1920 to the depression (brown shaded area) that ended in July 1921.

Even though the Great Depression of 1920–1921 was much shorter than the 1929 to 1938 Great Depression that followed, the decline for the U.S. economy was much steeper. The chart below depicts the 33% decline for U.S. Industrial Production during the 1920–1921 Great Depression.

The chart below depicts the S&P 500’s 32% decline from its pre-Great Depression high to its July 1921 Great Depression low.

Before revered U.S. economist, Milton Friedman’s death, he blamed the Fed for causing the First Great Depression from 1920 to 1921 because they continued to raise the discount rate after the recession had begun in 1920. He also blamed the Fed for extending the duration of the Second 1929 to 1938 Great Depression.

Mistake 2: 1926−1928 Rate hikes created 1929 stock market bubble and depressed home prices

An extended period of inflation ended in June 1926 and was followed by 35 consecutive months of either zero inflation or deflation, which ended in June 1929. Instead of lowering its discount rate to fight deflation the Federal Reserve made its second mistake by steadily raising the discount rate from 3.5% in June 1926 to 5.0% in 1928. The increase in the discount rate resulted in the S&P 500 increasing by 80% from 1926 to 1929. However, the U.S. home price index declined by 12.1% from 1926 through 1929, as depicted in the chart below. The Federal Reserve’s fourth mistake (covered below), caused the home index to continue to decline until 1933. From 1925 to 1933, the index declined by 30.5%.

PLEASE NOTE: Deflation’s impact on nominal dividend and bond yields is exactly opposite than inflation. To calculate a real (adjusted for CPI) yield, when there is deflation the rate of deflation is added to the nominal yield. To calculate a real (adjusted for CPI) yield, when there is inflation the rate of deflation is subtracted from the nominal yield. Assuming the nominal yield is 5% and inflation rate is 3% the real yield is 2%. If the deflation rate were also 2% the real yield is 7%. The chart below depicts the S&P 500, its real and nominal dividend yields and the CPI (inflation & deflation) from July 1926 to June 1929. The S&P 500’s historic real dividend yield high was why the index increased by 80% from 1926 to 1929.

Mortgages were unaffordable from 1926 to 1929 because the real yields for U.S. Treasury bonds and the S&P 500 Dividend were near all-time highs. The above chart depicts that the S&P 500’s real (inflation-adjusted) dividend yield reached as high as 8.4% in April 1927, which compared to its nominal yield of 5.04%. The red bars also depict the deflation for the period. The much higher real vs. nominal yield during the noninflationary period motivated the public to not spend or buy homes and to instead buy dividend paying stocks and U.S.Treasury bonds from 1926 to 1929. This is the reason the S&P 500 went to a bubble high in 1929. The high real yields motivated the public to avoid investing in real estate and other real assets.

PLEASE NOTE: The Home Price Index’s steady decline which was caused by the Federal Reserve’s discount rate being too high from 1920 to 1933, resulted in the U.S. public: 1) lacking confidence in the economy and, 2) excessively over speculating in the stock market.  The Fed was myopic in 1928 and 1929. It did not consider to lower the discount rate to inflate the economy since it was preoccupied by an overheated stock market. See, “Warning Signs Investors Ignored Before the 1929 Stock Market Crash”, Dave Roos, Updated Apr 27, 2021, HISTORY. What the Fed should have known was that raising a discount rate in a deflationary environment was THE catalyst to overheat both the bond and the stock markets. The hikes resulted in U.S. Treasury and S&P 500 dividend yields being near their all-time highs during the period. Hence, the Federal Reserve’s discount rate policy extended the Second U.S. Great Depression.

The chart below depicts that the AlphaTack PE multiple (AT/PE) almost tripled from 12.03 in 1926 to 32.66 in 1929. It fully supports the S&P 500 being extremely overvalued in 1929.

More about AlphaTack’s proprietary AT/PE, the only multiple which adjusts for CPI (inflation & deflation) is available at AlphaTack.com.

The Fed should have been steadily lowering its discount rate during the extended noninflationary period. Lower discount rates would have resulted in the U.S. economy inflating, which would have reduced the fervor and prices for U.S. stocks. By raising instead of lowering the discount rate, the Fed “threw gasoline on a fire” that was already roaring because inflation was non-existent. The Fed’s mistake resulted in the S&P 500 climbing to a bubble high in September 1929. Because the Fed did not lower the discount rate between 1926 and 1929 to inflate the U.S. economy, it was perhaps the biggest contributor to the “Roaring 20s”, which ended with a stock market crash and the Second U.S. Great Depression.

Mistake 3: August and September 1929 rate hikes guaranteed a severe contraction of the U.S. economy

The Fed’s third mistake, August and September 1929 rate hikes — when combined with its second mistake — was the root cause of the nine-year (1929–1938) contraction of the U.S. economy that infamously became known as “The Great Depression”. The Fed became hyper-sensitive after the First Great Depression debacle (1920–1921) and adopted a very defensive strategy to fight inflation. This included the Fed acquiring a hairtrigger policy to implement discount rate hikes. Whenever a new bout of inflation occurred, which is what happened in July 1929 when the Fed fired before asking questions.

The yellow circle in the chart below depicts inflation rearing its ugly head for the first time since June 1926 when it increased from 0% to 1.17% in July 1929. The red circle depicts the Fed’s raising of its discount rate from 5.0% to 6.0% by September 1929. The second September 1929 rate hike coincided with the S&P 500’s September 1929, all-time high.

Worse, the Fed raised its discount rate at the exact point in time when it should not have. The fragile U.S. economy was still in the process of recovery from the horrible post deflationary period caused by the First Great Depression.

The brown shaded area in the chart below depicts the Second Great Depression, which began in August 1929 and ended in June 1938. The red area near the middle of the chart and below its axis depicts the extended deflation period which plagued the Second U.S. Great Depression.

Mistake 4: 1931 to 1933 deflationary rate hikes (depicted above) extend the duration of the Second Great Depression

The nine-year Second Great Depression was much longer than the 19-month First Great Depression of 1920 to 1921. The Federal Reserve’s irrational discount rate-raising policy was the cause.

The light blue bars in the chart below depict that the Fed was proactive in quickly lowering its discount rate after the October 1929 stock market crash. The Fed steadily lowered its discount rate from 6% in October of 1929 to 1.5%, in June 1931. The central bank, then…abruptly and irrationally raised the rate from 1.5% to 2.76% in October 1931, and to 3.5% in November 1931. The red bars below the chart’s axis depict the U.S. in the midst of a deflationary crisis that began in February of 1930 and did not end until October 1933. CPI for October 1931 was –9.70% and remained in a negative-high single- to double-digit range until June 1933. The S&P 500’s all-time dividend real yield high of 24.9%, depicted by the purple bars was reached in June of 1932. The dividend yield high coincided with the S&P 500’s low for the 20th Century.

Because of the exceptionally long period of high deflation:

• • Consumers saved instead of spending
  • Investors sold their real assets including real estate and precious metals to invest in dividend-paying stocks and bonds
  • Businesses delayed making capital expenditures into the future to obtain lower prices

Instead of raising the discount rate, the Fed should have been lowering the discount rate to 0 or below 0 to motivate consumers and businesses to spend instead of saving.

PLEASE NOTE: Deflation is the worst of the CPI’s two inflation/deflation evils. It reduces and delays both consumer spending and business capital expenditures, which negatively impact GDP. The chart below depicts that capital spending, consumption, and GDP in 1931 subsequently declined to their lows in 1932 and 1933. All three did not exceed their 1929 highs until 1937. 

Upon deflation becoming embedded into an economy, purchase decisions are pushed into the future. Deflation fosters a “price will be lower in the future” attitude. Deflation by design can only occur during an economic recession or depression. At the peak of a deflationary period, which always coincides with a bottom for an economy and stock market, the value of financial assets — including stocks, bonds and cash — increases. The value of real assets — including real estate and gold — decrease during extended periods of deflation.

The chart below depicts that the decline in consumption and capital expenditures resulted in U.S. GDP not reaching its 1929 high until 1937.

All of the Fed’s four policy mistakes from 1920 to 1933 were ill-timed. These irrational discount rate hikes caused the following:

• • First U.S. Great Depression (1920−1921)
  • 1929 stock market bubble
  • Extension and severity of Second U.S. Great Depression (1929−1938)
  • U.S. home price index to decline by 12.6% from 1920-1938, which encompassed the First and Second U.S. Great Depressions.

The Fed did not learn from mistakes made between 1920 and 1933. Instead, it repeated them in 2020 and 2021. Thus, the stage has been set for the Third U.S. Great Depression.

Fed 2020 Policy Mistake

— The Fed Not Beginning to Raise Its Discount Rate by the End of 2020 —

After the S&P 500’s March 2020 crash the Federal Reserve lowered the discount rate from 2.25% to 0.25%. By the end of 2020 there was no rational for the Fed to maintain the 0.25% rate. The S&P 500 had completely recovered. The index had reached a new all-time high by August 2020 and its gain for 2020 was 16.26%. In December of 2020 the economy was well positioned to recover as a result of the second round of economic stimulus checks to citizens and businesses, and the availability of the first vaccine.

If the Federal Reserve had begun raising the discount rate in late 2020 it would have resulted in the S&P 500 trading relatively lower than the levels it traded at in 2021. A lower S&P 500 would have increased its dividend yield, which in turn might have resulted in the yield remaining positive instead of becoming negative in February 2021. A steady increase in the discount rate in 2021 would have led to real estate prices also being relatively lower. This would have cooled consumer spending which would have reduced the risk of severe inflation. Steadily rising housing prices ― to all-time highs ― is among the key factors for inflation becoming entrenched.

PLEASE NOTE: The 2020 policy mistake of maintaining a historically low discount rate resulted in the Fed Jeopardizing the U.S. economy should a recession or other extraneous U.S. or global economic events occur. By maintaining an abnormally low 0.25% discount rate from March 2020 to February 2022, the Fed put itself in the position of being unable to sufficiently lower the discount rate to stimulate the U.S. economy. In a May 2022 interview, Federal Reserve Chairman, Jay Powell, admitted the mistake. See “Fed chair says interest rates should have gone up sooner”, Rachel Siegel, May 12, 2022, Washington Post.

Fed 2021 Policy Mistake

— Not Raising Its Discount Rate in April of 2021, When Inflation Reached Its Highest Level Since October 2008 —

The Fed’s 2021 policy mistake was identical to its policy mistake that led to the first 1920−1921 U.S. Great Depression. The Fed maintained its discount rate at 3.75% from October of 1915 to November of 1917, a 26-month period within which inflation began at 0.99% and ended at 17.39%. In May of 1918 the Fed raised the discount rate to 4.56% and maintained the rate until November of 1919. From the beginning to end of this 18-month period, inflation went from 13.28% to 13.51% and reached as high as 20.74%.

The chart below depicts inflation and the Federal Reserve discount rate from 2000 to 2022, graphically illustrating the Federal Reserve maintaining its discount rate at 0.25% from June 2020 to February 2022. During this 21-month period, inflation accelerated from 0.12% to 7.87%.

The no-discount-rate-hike mistake resulted in a repeat of the Fed’s 1926−1928 policy mistake that resulted in the S&P 500 reaching a bubble high in 1929. From April of 2021, a month that had the highest inflation rate since October of 2008, the S&P 500 increased by an additional 21.2% through the end of December 2021. The S&P’s annual gain for 2021 was 26.89%, the third highest since 1997. There were more historic all-time highs in 2021 than the entire decades of the 1970s and the 2000s combined.

Please see “2021 Was One of the Best Years in Stock Market History” Ben Carlson, January 2, 2022, Awealthofcommonsense.com.

The 100-year (1923−2022) chart below depicts the AlphaTack PE (AT/PE) multiple for the S&P 500 near its all-time high in December of 2021.

PLEASE NOTE: The 2021 delayed rate-hike mistake made the U.S. economy extremely vulnerable because it enabled the S&P 500’s AT/PE multiple to reach 51.88 at December 31, 2021. This high multiple increased the probability of extreme volatility for the S&P 500, which subsequently occurred during the first five months of 2022 ― setting the stage for the index to experience a spectacular decline. Such a headline decline could easily cause a recession, or increase the intensity of an existing recession. Such a recession would be followed by a significant reduction in consumer and capital spending, the two root causes for an economic depression.

AND…

PLEASE NOTE: From my analysis of the history of the Fed and its attempts to manipulate the U.S. economy by irrational discount rate hikes, I fully understand why the most-revered U.S. economist, Milton Friedman, lambasted the central bank. From its inception in 1913 to the present day, the Fed has been clueless regarding simple economics. The 2021 “transitory inflation” warnings of current Fed Chairman, Jay Powell, were laughable. Any rational person would conclude that $5 trillion ― equivalent to 20% of a government’s GDP ― given to its citizens would disincentivize them to work and incentivize them to increase their spending. The only logical conclusion would be a subsequent bout of high- and difficult-to-eradicate inflation.

Common Denominators Shared by 2022, 1920 and 1929

• • 1920 & 2022: During both periods the Fed was hesitant to hike rates, and waited until inflation rapidly accelerated before taking action. Inflation accelerating from 1917 to 1920, resulted in the Fed being left with no alternative but to hike rates into a slowing economy. Because inflation has been accelerating from 2020 to 2022 the Fed has no choice but to hike rates aggressively, even though the U.S. economy has been slowing. See (U.S. GDP declined by 1.4% for Q1 2022).

• • 1929 & 2022: The Fed hiking the discount rate during its 1926 to 1929 deflationary blunders created the 1929 S&P 500 bubble high. (Likewise, the Fed maintaining an abnormally-low discount rate policy from 2020 to 2022 led to the January 2022 S&P 500 bubble high.) The chart below depicts the S&P 500 during the September 1926 to June 1938 period, which encompasses the second Great U.S. Depression from 1929 to 1938. The chart illustrates the S&P 500 being at a record AlphaTack PE (AT/PE) multiple high of 32.66 in September of 1929. The high 1929 AT/PE resulted in the index’s AT/PE declining to 25.8 at the S&P 500’s April 1930 post 1929 crash recovery high. The 25.8 AT/PE which ranked among the S&P 500’s highest of its AT/PE’s since 1871, was the obstacle that prevented the S&P 500 from recovering to within 10% of its all-time high. Climbing to a 10% or less percentage decline from the all-time high would have enabled the index to regain the momentum it had prior to the 1929 crash. Instead, the S&P 500 recovered to only within 19.5% of its high, and then reversed to its June 1932 low ― a dramatic decline of 85% from the all-time high.

The S&P 500’s inability to quickly recover to within 10% of its high, and instead to continue to the 85% decline at its low for the 20th and 21st centuries was one of the major causes for the recession that began in August of 1929 transforming into the second Great Depression. This nine-year depression that ended in 1938 not only had a much longer duration, but was much more severe than the first Great Depression of 1920 to 1921.

The 1918−1924 chart below for the S&P 500 and its AT/PE multiples includes the first U.S. Great Depression (1920−1921). The chart illustrates why the depression was much less severe than the second Great Depression (1929−1938). The much lower AT/PE of 26.3 at the S&P 500’s 1919 high enabled the index by May 1922 to recover to within 10% of its August 1919 all time-high. Because the AT/PE in May of 1922 was only 4.3, the index was then able to reach a new all-time high by November of 1924.

Finally, the lower AT/PE of 26.3 at the high of 1919 vs 32.66 at the high of 1929, resulted in the S&P 500’s percentage decline at its First Great Depression low being 32%. The decline of 45% for the Second Great Depression’s initial low, as depicted in the above chart and which proved to be an interim low, was much greater and was therefore much more depressing or demoralizing.

Please Note: The AlphaTack PE (AT/PE) was developed by AlphaTack to adjust the PE multiple for inflation or deflation. The traditional PE that has been taught in business schools since the late 19th century, plus other proprietary PE multiples (including the Shiller PE), do not adjust the multiple for inflation or deflation. The AT/PE is the only PE that adjusts the multiple for inflation, and the only PE multiple that can calculate a negative PE ― indicating extreme undervaluation. For more about the AT/PE click here.

The table below depicts the inflation rate, discount rate and the dividend yield for the S&P 500’s 2022 peak, and its two prior infamous peaks in 1929 and 2000. Metrics in the table depict that the S&P 500’s 2022 peak has significant disadvantages versus its 1929 and 2000 peaks. These disadvantages reduce the probability of the S&P 500 to quickly recover to within 10% of the 2022 peak — should a minimum decline of 30% occur.

At the 1929 peak:

i) there was no inflation (0.00%);
ii) the dividend yield was positive (2.95%); and
iii) the Fed was well-positioned to lower the discount rate to stimulate the economy (6.0%).

Advantages present at the 2000 peak were:

i) moderate inflation (3.76%); and
ii) a discount rate of 5.34% well-positioned to be lowered by the Fed.

Based on the S&P 500’s metrics at the January 2022 peak, the index is woefully disadvantaged, because:

i) Fed’s discount rate (0.25%) was at a historic low;
ii) increasing inflation (7.48%); and
iii) the S&P 500’s real or inflation-adjusted dividend yield (–4.86%).

Third U.S. Great Depression

Before an economic depression can begin it must be preceded by a recession, as was the case prior to both U.S. Great Depressions. Transformations from recessions to depressions are caused by any or all of the following:

• • Dramatic stock market declines
  • Spikes in unemployment
  • Mortgage and interest rate increases
  • Declines in consumer and capital spending

The 2022 pre- Great-Depression-conditions harbor conditions characteristic of the first and second U.S. Great Depressions. Consequently, the third U.S. Great Depression has the potential to be the worst of the three, because 2022 manifests similar pre-depression characteristics, as in:

• • 1919 ― when the Fed allowed inflation to accelerate before raising its discount rate; and in
  • 1929 ― when the S&P 500 went to a bubble high resulting from Fed’s 1926-1928 policy mistake

Additionally, the S&P 500’s real dividend yield has been negative since February of 2021. This increases the probability for the index to have a significant percentage decline. Such a decline would be a catalyst to transform a recession into a depression. Please see “Inflation to Shoulder Blame for 79.9% S&P 500 Decline“, Markowski, June 4, 2022, AlphaTack.com. This in depth article about the S&P 500’s performance during its negative yield periods from 1871 to 2020 provides the math supporting the index declining by 79.95% from its January 2022 high to 965.82.

The S&P 500 having a negative dividend yield significantly increases the risk for a dramatic decline, because Generational Investors ― the world’s oldest and largest ― will not buy until the index’s dividend yield becomes positive. Because generational investors have more than 100-year investment time horizons, they are the world’s most disciplined. They include family offices, endowments, public pension funds, sovereign wealth funds, and Swiss banks…the world’s first generational investors. At 12/31/2021, the aggregate $69.1 Trillion of generational investor assets were equivalent to 129% of the $53.4 Trillion value of the entire U.S. stock market. Please see, “S&P 500’s Bottoms Occur Only When Generational Investors Buy!“, Markowski, June 5, 2022, AlphaTack.com.

Finally, based upon my research of secular markets, the S&P 500 and the U.S. economy face another risk. The secular bull market that began in 2009, ended when a new secular bear market began on January 4, 2022. This bear will be the cause of a 47% to 85% decline for the S&P 500. The decline ranges are based upon the performance of the S&P 500 for all of its secular bear markets since 1929, as depicted in the table below.

Probability High for 79.95% S&P 500 Decline and Third U.S. Great Depression.

All investors should immediately begin to prepare for extreme U.S. stock market volatility, which is inevitable, by doing the following:

• • View 90/10 crash protection strategy video at bottom of page
  • View AlphaTack.com’s secular bear market educational videos at bottom of the page
  • Liquidate all blue-chip shares, mutual funds and Exchange Traded Funds

Cash should be invested in any or all of the following:

• • U.S. government 2-year treasury notes*
  • Long/short index hedge funds**
  • Hedge/Venture capital funds**
  • Private technology startup and early-stage companies**
  • Select microcap companies and penny stocks**

*View the 90/10 Crash Protection video at bottom of the page to understand why
**Available through AlphaTack‘s strategies via referral to advisors and funds.

Never more salient and urgent than today, the AlphaTack.com slogan “Growing Assets Against the Wind”… reflects the wisdom inherent in our philosophy.

The chart below depicts the performance of AlphaTack’s Bull & Bear Tracker, which gained 224% vs. 51% for the S&P 500 from March 2018 to May 2022.  The Bull & Bear Tracker is an ideal secular bear market investment vehicle since it fully leverages extreme volatility. The three yellow shaded areas on the chart depict the algorithm’s gains vs. the S&P 500’s declines for the 2018, 2020, and 2022 volatile periods. For more information about BBT go to www.alphatack.com.