13 Dec Looking For A Knight (Q3-22)

The U.S. Federal Reserve (“Fed”) is belatedly correcting its mistaken narrative of transitory inflation. Despite their antipathy to inflation and the powerful tools available to wield against it, central bankers around the world missed the runaway inflation they helped create. We have been here before. In the 1970s, the Fed was making decisions based on data that was eventually proven to be wrong, specifically very low estimates of price inflation. In a 2004 report, the Fed economist Edward Nelson wrote that the most likely cause of inflation during the 1970s was “monetary policy neglect” – the Fed failed to understand that by increasing the money supply it was creating more inflation.

Paul Volcker, who was Fed Chairman from 1979 to 1987, recognized that inflation was the result of the marriage of two cousins: asset inflation and price inflation. “The real danger comes from [the Fed] encouraging or inadvertently tolerating rising inflation and its close cousin of extreme speculation and risk taking, in effect standing by while bubbles and excesses threaten financial markets,” Volcker wrote in his memoir⁵. Volcker’s predecessors had encouraged these risks, but he would not. Market interest rates were already high by historical standards, but inflation was still higher, growing by then at an annual rate of close to 15 percent, the fastest ever in the United States during peacetime. Fed economists at the time, running their models, concluded that a recession was likely, and soon. Volcker’s strategy involved letting interest rates rise in 1980-81 to levels unparalleled, then or since, and to become strongly positive in real terms. Fed funds rates rose to over 20%. Ten-year Treasury notes to over 15%. Thirty-year fixed rate mortgage rates rose to over 18%. The prime rate reached 21.5%. Volker will be remembered as the “Federal Reserve knight who killed inflation.”⁶ It remains to be seen whether current Fed Chairman Jerome Powell will be able to wield Volcker’s sword.

Then and now, inflation was not an outside force attacking them, as politicians and central bankers both like to portray it, but an endogenous effect of government and central bank behavior. Volcker’s successors, beginning with Alan Greenspan, focused solely on consumer price inflation, probably because it was easier to track but more likely because it was more politically popular to fight price inflation than asset inflation. The Fed could keep cutting rates and keep increasing the money supply, just as long as the price of goods and services did not rise too quickly. The price of assets was ignored. It is always controversial when the Fed engages in restrictive monetary policies and doing so to burst an asset bubble causes immediate pain: “To raise interest rates in the face of a bubble is always to pay a certain price to head off an uncertain threat—and to incur the wrath of politicians and the public, who love nothing better than a soaring market,” wrote Sebastian Mallaby in his biography of Greenspan. When asset inflation is high, people call it a “boom” and do not complain. In July 1998, Greenspan warned that stock prices might be unsustainably high, which made investors panic expecting that the Fed would raise rates and tighten the money supply. Between July and August, stock market prices fell nearly 20 percent, prompting the Fed to cut rates again from 5.5% to about 4.8% in just a couple of months. In mid-November 1998, the Fed cut rates again. The stock market rocketed higher: in 1999, the S&P500 rose 19.5% and the NASDAQ jumped more than 80%. Since price inflation was not rising, and labour costs remained subdued, Greenspan argued that cutting rates would act as “insurance” against a debt crisis in Russia and the failure of Long-Term Capital Management, a highly-levered hedge fund, that were threatening to destabilize markets at the time. Although the Fed Chairman also acknowledged the impact of low interest rates on the stock market and initially hesitated in easing – “I do think the concerns about an asset bubble are not without validity, and that is where I have my greatest concerns about easing,” Greenspan said⁷ – he fomented what other Fed governors called a “bubble economy syndrome.”⁸

A key pillar of Greenspan’s policy framework as Fed chairman was to control price inflation, ignore asset inflation, and then bail out the financial system when asset prices collapsed. When signs of price inflation were starting to emerge in late 1999/early 2000, the Fed increased rates and then quite suddenly investors re-examined valuations in a world where the cost of money was increasing. The stock market crash of 2000 wiped out US$2 Trillion of value and prompted pleas from bankers, investors and politicians for help. Greenspan obliged and began quickly cutting interest rates to 3.5% by August 2001. Then, on September 11, 2001, terrorists attacked the United States using hijacked airplanes, killing nearly three thousand people and throwing the economy into a tailspin. The Fed responded with more interest-rate cuts and the cost of short-term lending stayed around 1% until 2004. In June 2004, signs of price inflation were appearing in the economic data and Greenspan began to raise rates slowly. Perhaps too slowly, as they were still accommodative and incentivizing speculation and easy lending, and eventually stimulating a housing bubble. Houses, like stocks, were described as a key source of middle-class wealth and a vital retirement investment, so the inflation of their value was welcomed and even celebrated. Between 2003 and 2007, the average home price in the United States rose by 38 percent, to the highest level ever. The seeds were sowed for the worse economic downturn since the Great Depression. The Greenspan era setup a permanent pattern for how the Fed would let asset bubbles inflate and come to the rescue when they would burst. This entrenched a financial regime more tolerant of moral hazard that has lessened risk aversion and ensconced the Fed as lender of last resort.

Volker knew that the job of the Fed was to take away the punch bowl just before the party gets going. Unfortunately, central banks wait too long and when the risks become evident the damage is done and the problem becomes much harder. This is where Powell finds himself today. Volcker’s inflation busting program triggered a sharp recession, and drew strong condemnation from businesses, investors and politicians. In September 1982, the New York Times reported that “the business failure rate has accelerated rapidly, coming ever closer to levels not seen since the Great Depression.” Powell does not appear to have such resolve and there is no political cover that allows the Fed, the Bank of Canada, or any other central bank in the developed world to inflict the brutal shock therapy needed to correct years of negative real rates and cheap leverage. Financial pain is inevitable and only its magnitude is uncertain. Even if rates are not raised enough to stop inflation, rising costs will hurt business and household incomes, banks will be loath to lend, and economic decisions will become distorted. Without a new Volker to slay inflation, investors should be prepared for more challenging market conditions over the next few years.

[5] Volcker, Paul A. “Keeping At It.” PublicAffairs. 2018
[6] Ullmann, Owen. USA Today obituary of Paul Volcker. December 2019
[7] Leonard, Christopher. The Lords of Easy Money: How the Federal Reserve Broke the American Economy. Simon & Schuster. January 2022
[8] Ibid. The phrase was attributed to Thomas M. Hoenig, President of the Federal Reserve Bank of Kansas City from 1991 to 2011.

Article excerpted from the Q3-22 investor letter