Investors all over the world should take note that the world’s most powerful and influential central bank, the US Federal Reserve, has in recent months changed its rhetoric from “higher for longer” interest rates and “vigilance” on inflation to accepting that rates have now “peaked”.1
US interest rate futures are now expecting seven quarter point interest rate cuts this year, beginning in March, taking the Fed Funds rate from 5.50% to 3.75% by year end.
This would represent a significant gamble that inflation is now under control since although “core” underlying inflation (excluding volatile food and energy prices) is down from its peak of +6.6%, it is still uncomfortably high at +3.9%, given the central bank “target” of just +2.0%.
If market expectations of 2024 US interest rates are correct, then it will be only the third time in the last 100 years (following 1971 and 1984) that the Federal Reserve would have embarked on an interest rate cutting cycle in peacetime and outside of recession with inflation still this high.
Still a “hot” economy
The US economy does not currently require more stimulus. It has rebounded by an astounding 40% (in nominal terms) since COVID (the fastest expansion since the 1970’s) and was still growing at a robust +3.3% (+6.0% nominal) real growth rate in Q4 2023. It currently has full employment with average wage increases of +5.2%.
US Federal deficit spending is currently running at 8% per annum which represents the biggest peacetime government stimulus outside of the Great Financial Crisis in 2008 and COVID in 2020. Running a “hot” economy is a political choice that usually results in higher inflation.
The Real Greatest Crash
It is a little-known fact that if you had been unlucky enough to buy the UK stock market at its peak in 1972, your real return over the subsequent decade would have been worse than buying US stocks just before the Wall Street crash in 1929.
This is largely because investors often confuse their “nominal” headline return with their “real” number, in which the value of money is adjusted for purchasing power after inflation.
Whereas the deflation of the 1930’s saw the value of money increase, the inflation of the 1970’s had the opposite effect, turning modest nominal returns into real losses in purchasing power. Inflation meant that £1 in 1970 was worth just 30p by 1980; $1 was worth just 50cents.
The 1970’s saw an “invisible crash” in stock markets: savers had been spared the pain of nominal losses, but wealth had still died, drowning slowly in a bubble bath of inflation.
Stocks can be an inflation hedge since corporate profits – like workers – live in a nominal world, are not fixed but will generally rise. Nevertheless, since high inflation erodes long-term investor confidence in the value of these profits, it usually results in the underperformance of “growth” stocks, since their value is based on estimates of cash-flow and dividends further in the future.
Resurgent inflation
We have recently witnessed the highest inflation since the 1970’s. There is much debate about whether its cause was temporary supply chain shocks largely caused by COVID lockdowns, or something more structural because of central bank money printing and reckless government spending.
I believe that inflation is largely a political choice that allows governments supported by central banks – who control the value of a currency through its quantity and rate of interest - to “pick the pocket” of investors, since inflation is in fact a form of “invisible” taxation on savers.
Repeating the mistakes of the 1970’s
Somewhat ironically, Fed Chairman Powell has regularly discussed the dangers of repeating the mistakes made by his predecessors in failing to adequately fight inflation during the 1970’s, warning in August 2022, that: "Restoring price stability will likely require maintaining a restrictive policy stance for some time. The historical record cautions strongly against prematurely loosening policy."2
The specific historical record is that of Arthur Burns, who was Chairman of the Federal Reserve through most of the 1970’s. Democrats in general regarded Burns as a Republican stooge. When he appointed his long-time economic adviser in 1970, President Nixon announced: “I respect his independence. However, I hope that independently he will conclude that my views are the ones that should be followed.”3
Following Nixon’s landslide re-election in 1972, esteemed financial journalist Sanford Rose wrote a famous article entitled “The Agony of the Federal Reserve” for Fortune magazine in which he accused Fed Chairman Arthur Burns and the Federal Reserve of caving into political pressure from President Nixon for loose monetary policy in 1971.4
Contemporary accounts suggest that Nixon constantly pressurised Burns for easier money, even leaking a fictitious story that Burns had asked for a $20,000 pay rise at the same time as he was pleading with the public for pay restraint and price controls.5
During the second half of 1971 Burns cut the Fed Funds rate from 5.5% to 3.5%, even though inflation, like now, was still running between 3 and 4%. “The word went out that 1972, by God, was going to be a very good year”6 confessed a Treasury official. US GDP growth accelerated from 3% in 1971 to 5% in 1972. But by 1974, Nixon was gone, and inflation had hit a new high of 12%.
Burns stated there was “not one grain of truth in the article”7 and raised the Fed Funds rate back to 5.5% at the beginning of the 1972 election year. The US Treasury also stopped dollar convertibility into gold in 1971, which de-anchored its currency. Nevertheless, the story of Burns stimulating the economy for Nixon has since become folklore of monetary policy becoming subservient to political expediency.
After leaving office Burns admitted that tighter monetary policy could have killed 1970’s inflation but that society prioritized full unemployment, so that “the Federal Reserve was itself caught up in the philosophic and political currents that were transforming American life and culture”.8
Investors should be aware that a similar political climate exists today. Would any mainstream politician dare to suggest, as UK Chancellor Norman Lamont did in 1991, that rising unemployment and recession would be “a price worth paying”9 to get inflation down?
Is Today’s Fed political?
Today’s Federal Reserve can also be subject to the same political criticism. Although Powell is a registered Republican, President Biden has appointed four of the seven Fed Governors, three of whom are labour economists with no experience of monetary policy.
Official data reveals Fed staff political donations since 2016 have been almost exclusively Democratic, whilst former Fed Vice-President Bill Dudley wrote a Bloomberg article in 2019 stating that “Trump’s reelection arguably presents a threat to the U.S. and global economy,” suggesting that his former colleagues “should consider how their decisions will affect the political outcome in 2020.”10
Watching the December FOMC press conference open-mouthed a preposterous suggestion occurred to me that old hawkish Powell might have been discretely deposed, displaced by a new dovish Democratically determined doppelganger. Or has the real Jerome Powell in fact committed Arthur Burn’s original sin of “prematurely loosening” monetary policy only to see inflation rebound and hit new highs in the years ahead?
Whilst fiscal and monetary stimulus can boost economies and asset prices in election year 2024, the long-term effects of “prematurely loosening” monetary policy risk repeating the mistakes of central banks from the 1970’s, with disastrous consequences for real investment returns.
Barry Norris
Argonaut Capital
January 2024
