It’s hard not to feel sorry for Arthur Burns, the former US Federal Reserve chairman, when we look back at the unpleasant inflationary years of the 1970s. He clearly felt his failure deeply (and that was a failure indeed, inflation averaged 6.5 per cent a year during his tenure in office), if the title of his 1979 lecture in Belgrade is anything to draw upon. He called it “the suffering of central banking.” It is useful to see it today, any investor wondering where to put his money in an era when inflation is rising once more?
The problem is, Burns said, that the Fed “merely” had the power to “restrict the money supply and create enough pressure in the financial and industrial markets to end inflation without much delay”.
The reason he didn’t do it was two things, first, politics. The Federal Reserve was immersed in the philosophical and political currents that were changing American life and culture,” in particular, the idea that “savings for bad times” were no longer a private but a public responsibility, add the consequent bias of deficit spending to increased regulations around the world. The economy and high taxes discouraged business investment with the inevitable result, an “automatic inflationary turnaround”.
Second, monetary policy is very difficult. Contrary to what most central bankers believe, there is no successful ultimate model, “monetary theory does not provide decision-making rules that are both consistent and reliable for central bankers,” Burns puts it. We may know that “too much money” will cause inflation, for example, but this knowledge “lacks mathematical precision”. The result? Surprises and mistakes in “all stages of the monetary policy creation process”.
Among the audience in Belgrade sat Paul Volcker, then the new chairman of the Federal Reserve, now known to do what Mr Burns felt he might do in the abstract: stamp out inflation. By mid-1981, the monetary policy tough guy made interest rates rise to nearly 20 per cent. At the time of his departure in 1987, inflation was hovering around 3.5 per cent.
A few years later, Volcker gave a speech entitled “The Triumph of Central Banking?” No wonder all central bankers today want history to remember as Volcker La Prinze. But note the question mark in his title, a recent scientific paper from analysts at Ned Davis Research notes that Volcker had the kind of backing from global and domestic politics that Burns might hardly dream of. And Fockler had a supply-side revolution for Ronald Reagan.
Reagan cut regulations and disbanded the Air Traffic Controllers Union in 1981, dismissing 11,359 air traffic controllers at once. Volcker saw this as a “turning point” in the fight once morest the wage-price spiral. There was also a sharp rise in low tax-stimulus investment in the US, along with a very beneficial productivity boom, add to all that the subsequent oil price crash in 1986, the dawning of globalization and the beginning of the computer age, and you get the picture, Volcker was lucky.
This date is important. Look at the environment in which current Federal Reserve Chairman Jay Powell operates, and you might wonder how he might have been Volcker without Volcker’s luck? The chance of a low-tax, regulated productivity boom seems slim under Joe Biden. There is no room for another boom in globalization, and with the US labor market still very tight, the risk of a wage-price “not unjustified” spiral remains very high.
If you use the 1980s as a reference point for the speed with which savvy central bankers can stamp out inflation, you might want to take the lessons of Volcker and Burns into account. Central banking success is more a matter of luck than skill.
Outside the US, you can watch Liz Truss, the UK’s prime minister, closely. There is something to former US President Ronald Reagan’s economic policies of tax cuts and tearing up regulations, and the productivity rhetoric of her government, as evidenced in Friday’s mini-budget unveiled by Chancellor Kwasi Quarting. The Bank of England may be regarding to get lucky.
None of this helps us know where inflation will end up: because so far most predictions have been wrong, I fear we should ignore most predictions. But the fact that we don’t know helps us a little bit on our investments, it reminds us that we have to build some collateral. It is almost impossible to do that in the United States. The S&P 500 is trading at an expected P/E of regarding 17 times, slightly above the historical average at a time when most other things are worse than average.
You can argue that it’s only regarding fair value if you assume interest rates won’t go above 5 percent and think in terms of dividend yield. But nothing else really worked. GMO’s current seven-year forecast indicates an annual real return for US stocks of minus 1 per cent. It really is suffering.
There is, however, a market where things are looking better. The UK, aided by the economic policies of TRACE, has reached an expected earnings multiple of nine times. Profits will of course be cut, as noted by JP Morgan, whose UK is now a better choice out of developed markets. But that is still a significant “assessment reserve”. Investors should use it.
