The Three-Year Lag the Fed Always Forgets

When the Fed aggressively hikes rates, it often ends up triggering a crisis of the very kind that it hopes to prevent. And seemingly, central bankers haven’t learned their lesson this time, either…

© Estate of Margaret Bourke-White / Licensed by VAGA at Artists Rights Society (ARS), New York, NY

Instead of Being Patient, It Aggressively Tinkers

Harry probably shouldn’t have left his friend Eddie alone to mind the store.

The two buddies split duties at their Missouri haberdashery “equally” – which in practice meant that Eddie stayed behind the counter and hawked shirts and “no-wilt” collars, while Harry gallivanted around town under the guise of business lunches.

Then the Depression hit – and Harry likely wished he’d paid a little more attention to what went on behind the counter.

“A flourishing business was carried on for about a year and a half,” he wrote later, “and then came the squeeze… [Eddie] Jacobson and I went to bed one night with a $35,000 inventory and awoke the next day with a $25,000 shrinkage…. This brought bills payable and bank notes due at such a rapid rate we went out of business.”

Harry and Eddie had to liquidate and file for bankruptcy – and they weren’t alone. The stock market crashed, business failures tripled, and company profits on average fell by around 75%. As prices plunged, employment ticked up toward 12% and more than a thousand banks closed their doors.

Oh, and here’s the kicker – this wasn’t even the Great Depression.

This was a severe, 18-month economic contraction – from January 1920 to July 1921 – that’s largely ignored in history books. When it’s mentioned (rarely), it’s called the “Forgotten Depression.”

It all started during the post–World War I boom. At that time, the U.S. was still on the gold standard – each U.S. dollar was backed by a corresponding amount of the precious metal. There was a post-war surge in spending to rebuild the neglected country after so much had been spent overseas to support the troops. The resultant increase in the money supply and in consumer prices caused a massive drain on the country’s gold reserves.

To cool down the economy and slow the loss of gold, the Federal Reserve began to raise interest rates aggressively. It hiked rates from a low of 3.5% in 1917 to a then-record-high 7% by early 1920.

The Fed’s first big rate-hike cycle (the central bank had only been founded in 1913) took several months to weigh on the economy. But once it did, the consequences were dramatic. The Dow Jones Industrial Average fell by nearly 50%, and the U.S. suffered its sharpest drop in wholesale prices in history (worse than even the Great Depression that followed a decade later). 

The adolescent Fed didn’t immediately cut interest rates in response to this crisis. Following the guidance of Benjamin Strong – head of the Federal Reserve Bank of New York – the Fed instead held rates at these high levels for the better part of a year as the crisis played out.

Strong believed in the self-correcting nature of markets (that is, in the Invisible Hand). He figured that the only lasting solution to the post-war boom was a commensurate bust – and he was convinced the crisis would resolve most quickly without government interference. As he predicted in an early 1919 letter to his friend, economist Edwin W. Kemmerer…

“I believe that this period will be accompanied by a considerable degree of unemployment, but not for very long, and that after a year or two of discomfort, some losses, some disorders caused by unemployment, we will emerge with an almost invincible banking position, with prices more nearly at competitive levels with other nations, and be able to exercise a wide and important influence in restoring the world to normal and livable conditions.”

Strong was uncannily correct… right down to the “year or two of discomfort.” The Forgotten Depression ran its course in less than two years. And by 1922, the economy had fully recovered. As legendary financial newsletter writer Jim Grant – author of the definitive book on this crisis – noted in the Wall Street Journal in 2015: 

“In the absence of anything resembling government stimulus, a modern economist may wonder how the depression of 1920-21 ever ended. Oddly enough, deflation turned out to be a tonic.

“Of course, the year-and-a-half depression must have seemed interminable for all who were jobless or destitute. It was, however, a great deal shorter than the 43 months of the Great Depression of 1929-33. Then too, the 1922 recovery would bring tears of envy to today’s central bankers and policymakers: Passenger-car production shot up by 63%, for instance, and the Dow jumped by 21.5%. ‘From practically all angles,’ this newspaper judged in a New Year’s Day 1923 retrospective, ‘1922 can be recorded as the renaissance of prosperity.’”

Prosperity returned a bit too late for young Harry, who lost his haberdashery in the bust. But, as his cousin Mary acknowledged, no one who knew him was surprised he went bankrupt.

“Well, we of course were sorry that he didn’t make a go of it,” she said years later in an article about her cousin, “but we couldn’t feel that that was Harry’s life work any more than farming had been, and I think we just took it without too much concern, because we all felt that he hadn’t gotten into the thing that would bring out the best that was in him.”

Not to worry, though – Harry eventually found his niche. A couple of decades after the Truman & Jacobson men’s clothing store closed its doors, Harry S. Truman became the 33rd president of the United States.

Selective Amnesia 

The Forgotten Depression carried several critical lessons for central bankers.

It illustrated that busts are a natural and necessary consequence of booms – while painful, they’re essential for liquidating bad debts and malinvestment and for “resetting” the system.

It showed that these crises can resolve themselves quickly without government interference.

And it highlighted that monetary policy acts with a significant lag. Specifically, the effects of rising interest rates don’t begin to show up in the economy until two to three years after tightening begins, regardless of how aggressive central bankers act.

The lag likely has to do with the term structure of debt – most borrowers typically don’t have to refinance at higher rates immediately. Plus, even the weakest borrowers often have some amount of equity or savings they can rely on initially. But regardless of the reasons, these delayed effects have proven to be remarkably consistent over time.

Unfortunately, like the Depression of 1920-21 itself, these lessons were quickly forgotten, if they were ever learned at all. (It doesn’t help that the University of Chicago’s Center for Research on Security Prices database – the source for most historical stock market and financial information today – only goes back to December 1925.)

In virtually every boom since, the Fed has sought to avoid busts at all costs. It has typically intervened aggressively to stop them at the first signs of significant trouble in the markets or the economy. And though Fed officials often give lip-service to Milton Friedman’s 1959 insight about the “long and variable lag of monetary policy,” their dogged impatience over the past 100 years suggests they’ve yet to take this enduring lesson to heart.

Delayed Crises Are the Rule… Almost Without Exception

A look at financial history since the 1920s shows this lag between rising rates and their inevitable economic and financial consequences is not just remarkably consistent, it’s also typically longer than just about anyone – including those controlling the levers at the Fed – expects in real time.

This unfortunate reality has led to a predictable yet recurring problem. As you can see in the chart below, when the Fed aggressively hikes rates, it often ends up triggering a crisis of the very kind that it hopes to prevent.

This dismal pattern began a few years after the Forgotten Depression. As a new speculative boom took hold during the second half of the decade, the Fed started raising rates sharply in early 1928, ultimately reaching a peak of 6% in 1929.

But it wasn’t until October 1929 – roughly two years from the start of that tightening cycle – that the stock market began its historic plunge (the Dow would go on to drop 89% before bottoming in 1932). And it was still another year after that before the Great Depression went global in early 1931. That’s when Austrian bank Creditanstalt – one of the largest and most important banks in Europe – collapsed, setting off a deflationary crisis that quickly spread across the continent.

The 1960s and ‘70s saw this cycle repeat several times.

In mid-1967, in an effort to fight inflation, Fed chair William Martin began an aggressive tightening cycle. In just over two years, he more than doubled the fed funds rate from 3.75% to nearly 10%.

Yet, it still took another 10 months – and three years in total – before trouble began. Economic shockwaves followed the failure of railroad giant Penn Central, at the time the largest corporate bankruptcy in history. Since the railroad controlled a third of the nation’s passenger trains and a majority of freight traffic in the Northeast, its collapse created significant economic and financial market fallout.

In addition to the obvious disruption of interstate trade and significant losses among the company’s many pensioners, the collapse triggered a liquidity crisis in the short-term corporate-debt market that nearly bankrupted renowned investment bank Goldman Sachs. 

And Still No Lesson Learned

Martin’s successor – the much-maligned Arthur Burns – presided over a similar tightening cycle a few years later.

Despite his legacy of being “soft” on inflation, the Burns Fed aggressively raised rates from less than 4% in early 1972 to a whopping 13% in July 1974. And it was not until October 1974 – nearly three years into the tightening cycle – that his Fed finally relented.

In that cycle, the central bankers feared the recent collapse of Franklin National Bank, the largest bank failure in U.S. history at that time, could trigger a financial crisis (much like the failure of Lehman Brothers several decades later).

Regulators quickly stepped in – orchestrating the first federal wind down of a major financial institution in history – and Burns cut rates back down to 5% to ease financial conditions, even as inflation remained high.

Even famed inflation-fighter Paul Volcker was a victim of this lag.

As many recall, Volcker held rates as high and as long as necessary to defeat inflation – rapidly pumping up the fed funds rate above 20% by 1981. 

But when Volcker finally gave up his fight in 1984 – again, roughly three years after his final tightening cycle began – it was not because inflation had been defeated. Consumer prices would continue to rise between 4% and 6% annually – well above the Fed’s target – for much of the next decade.

Rather, Volcker began cutting rates following the near-failure of Continental Illinois National Bank – the country’s largest commercial and industrial lender and arguably the first “too big to fail” bank – that threatened to trigger a financial crisis that spring.

Most notably, Volcker’s successor, Alan Greenspan, played a role in multiple such cycles in the following decades. Those lags culminated in the “Black Monday” stock market crash in October 1987, the savings-and-loan crisis in the early 1990s, the dot-com boom and bust in the late 1990s, and ultimately, the 2000s housing bubble and the Great Financial Crisis that followed.

And despite all that history could have taught him, former Fed Chair Ben Bernanke – who took over the reins from Greenspan in 2006 – was most famously fooled by the lag.

In a speech in March 2007 – almost three years after the start of the Fed’s most recent rate hike cycle – Bernanke assured Congress that the growing problems in the subprime mortgage market were “contained” and unlikely to impact the “broader economy and financial markets.”

Of course, we now know that the worst financial crisis since the Great Depression was already brewing, and the Fed would begin cutting rates in a panic just a few months later.

Bernanke’s misplaced confidence is among the biggest blunders in modern financial-market history. But as we’ve seen, virtually every Fed chair – along with most investors and market pundits – has made similar mistakes in every tightening cycle in U.S. history. 

The “End Game” Is Clear

That brings us to where we are now. 

You’ve likely read or heard commentary about the “surprising” resilience of the U.S. economy in recent months.

Over the past year and a half, the Jerome Powell-led Fed has raised short-term rates from near 0% to 5.5% – representing the most aggressive tightening cycle in history on a percentage basis.

Yet, despite total U.S. debt levels – including federal, corporate, and consumer debt – being roughly double what they were in 2007, these recent rate increases haven’t created any severe problems in the U.S. to date (outside of a handful of regional bank failures).

The lack of any significant fallout from the Fed’s aggressive hikes – so far – has led many investors to assume that “this time” really is different… That these moves will somehow successfully tame inflation without causing a financial crisis.

Unfortunately, today’s cheerleaders are likely to be disappointed, like countless others before them. 

Despite growing optimism that the Fed will achieve a “soft landing,” more than 100 years of history suggests a crisis is unavoidable. And we’re now approaching the period in the cycle – roughly two years after the first rate hike – when it is most likely to begin.

We’ve already witnessed significant stress in the banking system – though there will likely be more disruptions ahead. And we’re just beginning to see signs that the economy is teetering, including a slowdown in housing, manufacturing, and corporate profits, rising consumer delinquencies, and weakness in commercial real estate. It’s likely just a matter of time before another crisis begins.

But the delayed consequences of Fed policy isn’t the only predictable aspect of these cycles.

In each of these prior scenarios since the Great Depression, the Fed also aggressively reversed its policy as panic set in. And as these crises have become increasingly more severe under the growing pile of bad debts and malinvestment over the years, the Fed’s responses have also grown larger and more dramatic – flooding the economy with more liquidity and stimulus each time.

This trend suggests the next crisis – the “End of America,” as we’ve called it – will be one for the record books… And the Fed’s response to it will be among the biggest and most inflationary in history. Unfathomable amounts of money-printing are assured.

Here at Porter & Co., we believe the surest way for investors to protect – and even build – wealth in the years ahead is to own hard assets (particularly gold and Bitcoin) and the world’s most dominant, capital efficient businesses

However, it’s also important to understand that the Fed historically acts only after a crisis is already underway.

In the meantime, we could experience severe economic and market turmoil, including soaring unemployment and unprecedented market volatility. Investors who take on too much risk – even in the highest-quality equities – may be unable to weather the storm.

This is why we continue to urge investors to remain patient and conservative. The coming crisis will present a once-in-a-generation wealth-building opportunity to buy the best companies at bargain-basement prices – but only for investors who have the capital available to take advantage.

And rest assured, our paid-up The Big Secret on Wall Street subscribers can count on us to tell them exactly when this opportunity arrives. If you’d like to join them, click here to get started now.


In The Big Secret on Wall Street mailbag, Porter answers letters from readers. He cannot offer individual investment advice, but can respond to general questions.

Please email us at [email protected] to have your questions answered. We’d love to hear from you!

Today’s first letter is from M.V. who writes:

“I read with fascination your report on the shale revolution. I still have that report… lol. A couple of years later you warned about the oversupply due to the cheap capital and glut of oil. Amazing! Because of you I didn’t get wiped out. I was totally out of the market when the ‘plandemic’ happened. When oil went negative, I jumped in and went hog wild purchasing oil majors stock and sold when it doubled, tripled.”

Porter’s comment: Thanks for your note. I really appreciate it. 

You’ll find my complete thoughts on the energy sector in a newsletter I wrote earlier this year called “The Gods of Gas” about the Rice brothers and EQT. I haven’t really changed my mind about anything since then. Basic view: LNG is going to grow – a ton. Demand for oil will be a lot stronger than the Greens believe. And, the current ESG fad will create big gains for investors as the oil-and-gas industry has been relatively starved of capital. 

Great job jumping into oil at the bottom during COVID. What an incredible trade! 

I didn’t do that… but I did call the bottom – the day – of the markets in March 2020. And I recommended a slew of great businesses, virtually all of which soared. 

Our next letter comes from T.S., who writes:

“I wanted to write today to simply thank you for both your excellent work and for educating me these past 10+ years (which in turn enhanced the quality of my life). I found your presentation at the Stansberry Conference to be so well done. I feel exactly the same way.  

Not sure where I’d be today were it not for a former Denver friend (where I lived for many years), who introduced me to your Stansberry’s Investment Advisory newsletter.

Through Jason at Porter & Co. (who was terrific by the way), I became a Partner Pass Member last June so I hope I get to see you in 2024 at your annual event in Maryland.

I am visiting with my son this weekend, and plan to give him the letter you prepared for your son. Very excited to be sharing such valuable, lifelong information.”

Porter’s comment: What a wonderful letter. 

Thank you very much. As I’m sure you can imagine, that’s the kind of impact we’re trying to make on all our subscribers. And it’s nice to know that we accomplished that with you.

Porter & Co.
Stevenson, MD

P.S. If you’d like to learn more about the Porter & Co. team – all of whom are real humans, and many of whom have X accounts (formerly Twitter) – you can get acquainted with us here. You can follow me (Porter) here: @porterstansb.