Richard Vigilante, an old friend from the Reagan years, reminds us of another old friend John Rutledge who worked with Larry Kudlow, Dave Stockman and me on the 1981 presidential transition team. I asked Stockman to invite Rutledge because I admired his writings about rational expectations and markets but also because he was a wizard with a rare DOS laptop (I did not buy a PC until 1982).

Later that year, December 14, Rutledge wrote “Why Interest Rates Will Fall in 1982” for The Wall Street Journal. That is the article Vigilante recalls as “the most prescient prediction by an economist that I have ever read.” Arguably true, but it turned out being more prescient for 1983 than 1982. The fact that lower tax rates were not phased-in until 1983–84, rather than 1982 as Kemp-Kasten bill planned, was one big glitch in the timing. A prolonged inverted yield curves from the Volcker Fed was another.

Rutledge argued that “major changes in interest rates are usually caused by changes m how the public wants to hold its net worth. The point of this article is that the drop in inflation in the last 18 months is forcing households to restructure their wealth in a way that will force reductions in interest rates.” That is, lower inflation would make it less attractive to hold tangible assets like (houses and gold) hoping to sell them later for a capital gain and more attractive to hold stocks and bonds. Since a rising bond price means a lower yield, bond yields should fall.

Rutledge’s ingenious analysis directly repudiated conservative Keynesians (notably Stockman) who were loudly arguing in 1981 that projected future budget deficits would raise interest rates and absorb all the U.S. savings (forgetting finance is global), leaving little credit leftover for households or firms. The stubbornly fallacious argument that budget deficits raise bond yields was the reason reductions in marginal tax rates were foolishly put off until January 1983 (when tax rates were cut by 10%) and January 1984 (by another 10%).

What Rutledge could not possibly foresee at the end of 1981 was that the Fed would act as though there was no “drop in inflation” and would instead keep short-term interest rates at astonishingly high rates of 14–19% – usually higher than the yield on 10-year bonds (an inverted yield curve).

Modern readers may be surprised that inflation had dropped for 18 months by December 1981. The historical hoax that stubborn inflation in 1982 “forced” Fed Chair Paul Volcker to keep short rates far above inflation may persist because the public and press in the 1980s mistook foreign oil price shocks for domestic inflation, just as they do today. The Iranian revolution from January 1978 to February 1979 decreased global oil supply by 4 percent and led to an oil price increase of 57 percent; then starting in September 1980 the Iran-Iraq War decreased global supply by 4 percent and led to another price increase of 45 percent.

Core inflation does not remove all effects of such oil price spikes on the cost of producing and transporting goods and people (such as air fares). But core inflation is less misleading than all-items “headline” inflation. The Consumer Price Index, unlike the PCE index, also miscounted higher mortgage interest rates as housing inflation until 1983, so even the core CPI for 1980–82 is misleading.

As the graph shows, the Core PCE index of inflation rose at an annual rate of 10.1% in the first and fourth quarters of 1980, but that dropped to 7.3% by the last quarter of 1981 (as Rutledge noted), then to 5.5% in the second quarter of 1982, 3.1% in the second quarter of 1983, and 1.6% by December 1986.

Falling inflation confirmed the Rutledge forecast, yet the yield on 10-year bonds remained relatively high as the blue line indicated. Why? Because the Fed kept the federal funds rate (red line) as high or higher than the bond yield. The fed funds rate even remained above 14% from February to June 1982. Finance professors will tell you that is a recipe for recession, and this case it was a recipe for two recessions from 1980 to 1982.

While the Fed kept the yield curve inverted, or nearly so, the high fed funds rate kept the interest rate on money market funds so high it was almost foolish to shift into 10-year bonds whose value could fall with another round of fed funds rate hikes (which happened in 1983–84).

Once all tax rates were finally cut by 10% in 1983 and again in 1984, the Rutledge Model overwhelmed the Volker model even though the Fed put the fed funds rate back up with each tax rate cut. Real GDP grew by 4.4% a year from 1983 to 1989 (before interruption by another oil shock and renewed tax hikes). Inflation moderated most in those high-growth years and stocks did extraordinarily well, as Rutledge suggested. It is still a great read, but I might retitle it “Why Interest Rates Fell After 1982, Despite the Fed.”