Inflation, Back to the Future Part II?
“Trust in our currency is fundamental to good government.”
—Paul Volcker
Inflation – it is not often that one word summarizes the key factor affecting the equity and debt markets in a year, but this year that word does the trick.
In our May 2021 cover letter, titled “Inflation, Back to the Future?”, we discussed what was then a mere concern of impending inflation amongst market observers. The title ended with a question mark because some economists, including Paul Krugman, a Nobel prize winner, and Alan Blinder, a former Vice-Chair of the Federal Reserve, argued forcefully that inflation would not become a problem and that if it did materialize it would be a mere blip, or, in economic speak, “transitory.” Other economists disagreed, most vocally Larry Summers, President Clinton’s Treasury Secretary, who argued that authorities were implementing “the least responsible fiscal macroeconomic policy we’ve had for the last 40 years.”
That debate is now over and the results can be declared – team Summers has scored a knockout blow over team Krugman/Blinder. Unfortunately, that means we have indeed gone “back to the future,” and are experiencing the worst inflation since the early 1980s.
In response to this inflation, the Federal Reserve, which was caught flat footed by it1For example, in its “Summary of Economic Projections” published on December 15, 2021, the members of the Fed Open Market Committee projected that inflation in 2022 would range between 2 and 3% (see Figures 3.C. and 3.D), a prediction that proved to be wildly optimistic and incorrect. The Fed in this same publication predicted the Federal Funds Rate, which it controls, would reach 2% by the end of 2024, instead the rate reached 2.5% this July. One critic noted given these facts that not only can the Fed not predict economic outcomes, it also cannot predict what its own actions will be., began instituting in June 2022 a series of .75% increases in the short-term interest rate that it controls (known as the Federal Funds Rate). The last time the Fed instituted a .75% increase was in 1994. These successive large increases brought the Federal Funds Rate to its highest level in fourteen years. Increases to the rate will almost certainly continue at the Fed’s next meeting on December 13-14, and into 2023, with the open question being when the Fed will lessen the magnitude of the increases and then stop them altogether.
In approving these increases, one wonders if Jerome Powell, the current Chair of the Federal Reserve, envisions himself as the next iteration of Paul Volcker, the former Fed Chair who is widely credited with slaying the awful inflation of the 70s and early 80s by driving up interest rates to record levels. If not, there is no doubt that Powell is aware of the lofty pedestal on which Volcker’s reputation sits. (Volcker became Fed Chair in August 1979 when inflation was at 11%).
Powell’s actions have generated heated controversy, with some economists warning that the Fed is raising rates too aggressively too quickly, needlessly raising the risks of a severe recession in 2023, others arguing that the rate hikes are ineffective, others that they are still far too low, while still others assert that his actions are necessary to curtail the current inflation and to prevent it from becoming entrenched as an expectation for the future.
This debate as to the appropriateness of the Fed’s recent rate increases is not of mere academic interest – to the contrary, the purpose of the interest rate increases is to have a real effect on economic activity, and to slow this activity, causing economic pain for some. Indeed, while the recession of 1982 caused by Volcker’s rate increases may seem like ancient history, the fact is that that recession was the worst economic downturn since the great depression and caused deep suffering for the many millions of Americans thrown out of work, as the unemployment rate rose to just under 11 percent, a postwar high not exceeded until the shutdowns of March 2020.
Today, while the unemployment rate remains low, a fact that Jerome Powell, in the diplomatic language of Fed-speak, bemoaned during his press conference after the Fed’s November 2022 meeting, the dramatic rate increases that have occurred over the past nine months are beginning to ripple through the domestic and worldwide economy. Thirty-year mortgages, for example, are subject to an interest rate close to or over 7% , a cost of borrowing last seen over twenty-years ago, and double the rates in place only one year ago. Home buyers, as a result, are subject to a 73% increase in housing costs, according to Black Knight, a mortgage data company, causing home prices to fall.
Most importantly for our purposes, the Federal Reserve knew full well that its dramatic rate increases would adversely affect the value of the securities held by PMA clients. The market value of bonds, for example, will decline when interest rates go up. Accordingly, the bond markets in 2022 have had their worst performance in the last fifty years.2 PMA continues to believe that bonds are an important component of most portfolios, for the reasons explained by Daniel Berkowitz in “Bonds in a Rising Rate Environment.” Furthermore, rate increase of this magnitude and pace at the least created a substantial risk to equity prices, which have also declined dramatically.3 Stock prices are presumed to reflect the present value of companies’ future earnings, dividends or cash flows. To calculate the current value of these future dollars requires that an interest rate be used to “discount” them to the present. The higher the interest rate, the less future money is worth today. Therefore, under this theory, rates go up and stock prices go down.
Whether the Fed’s current policy is right or wrong, the fact is that its policy is set, and, having invested its entire credibility in its determination to use its power to curtail inflation, it is in no position now to change paths. Accordingly, with the Fed determined to slow economic activity, many economists and market participants expect a recession in 2023 which will, at the very least, lessen the demand for workers and, more likely, result in an increase in unemployment.
Nevertheless, in the early 1980s, as mentioned, the unemployment rate reached almost 11% as the Fed raised rates to 20% — today the unemployment rate is 3.7% and the Fed rate, even after the dramatic increases so far this year, is at no more than 4%, well under the rate of current inflation. Even if unemployment doubled, it would still be far less than what occurred under Volcker (and currently the Fed is predicting only a modest increase in the unemployment rate). This leads some experts to argue that the Fed’s increases to date are not close to sufficient to tame inflation.
Moreover, after two years of severe pandemic related hardships, and one year of large equity and bond market declines, if unemployment does increase materially in 2023 the political and social reaction would likely be fierce and a test of the Fed’s resolve. To a certain extent that political reaction is already beginning.
For these reasons, the title of this cover letter also ends with a question mark – will the large interest rate increases which the Fed is engineering cause a recession, as they did in the early 1980s, leading to unemployment and hardship, but in the end yielding the intended result, snuffing out this new inflation? Or will its actions be ineffective or counter-productive because this new inflation was caused by supply chain snares and other pandemic unique circumstances, as well as worldwide labor shortages? Or are the increases that the Fed is contemplating insufficiently large given how far behind the curve it got, and will it, as Volcker’s predecessors did, blink in the face of political blowback to any meaningful slowdown? Or will some other unforeseen event prove that in the “best laid schemes o’ Mice an’ Men” planning “may be vain” leaving “nought but grief an’ pain.”
While we cannot pretend to have the answers to these questions, our crystal ball is cloudy, history does suggest that PMA’s fundamental strategy, staying invested and not trying to time the markets by jumping in and out of cash, paid off well for those in the early 1980s who could follow it, notwithstanding the long periods of market uncertainty and pain which they would have had to endure. As reported by New York Times writer Jeff Sommer, in the late summer or early Fall of 1982, Volcker decided – although inflation was still in the 6-7% range – that his increases were having a worldwide effect and that it was time to pivot. This “had a startling payoff in financial markets” with the S&P gaining 15% for the year “and kept going.”
We suspect that the answers to the questions raised above will be known in the next 12-18 months, at which time it will be appropriate to write what we hope will be the final entry in this series, with a title ending with a period and not a question mark, “Inflation, Back to the Future Part III.”
