The writer is editor of Money Week
It’s hard not to feel sorry for Arthur Burns, Chairman of the US Federal Reserve, when you think back to the nasty inflationary years of the 1970s. He clearly felt his failure deeply (and it was a failure – inflation reached an average of 6.5% per year during his tenure) according to the title of a lecture he gave in 1979 in Belgrade. He called it “Central Bank Anxiety”. It’s useful reading today for any investor wondering where to put their money at a time when inflation is rising again.
The problem, Burns said, was that the Fed had “in the abstract” the power “to have restricted the money supply and created enough stress in financial and industrial markets to end inflation with little delay. “.
That he didn’t was a function of two things. First, politics. The Fed was “caught up in the philosophical and political currents that were transforming American life and culture” – in particular, the idea that “provision for bad times” was no longer a private but a public responsibility. Add the resulting bias toward deficit spending to increased regulation across the economy and high taxes that discouraged business investment and the result was inevitable: an automatic “inflationary twist.” .
Second, monetary policy is very delicate. Contrary to the belief of most central bankers, there is no definitive model that works: “monetary theory. . . does not provide central bankers with decision rules that are both firm and reliable,” as Burns put it. We may know that “excessive money creation” will lead to inflation, for example, but that knowledge “stops short of mathematical precision.” The result? Surprises and errors at “every stage of the monetary policy-making process”.
In the Belgrade audience sat Paul Volcker, the new Fed Chairman, and the man now known for doing exactly what Burns thought he could only do in the abstract: kill inflation. By mid-1981, the tough man of monetary policy had interest rates hitting nearly 20% and inflation on the run. By the time he left in 1987, he was hitting around 3.5%.
A few years later, Volcker gave a lecture titled “The Triumph of Central Banking? No wonder today’s central bankers all want history to remember them as a Volcker, not a Burns. But note the question mark in its title. A recent paper by analysts at Ned Davis Research points out that Volcker had the kind of support from domestic and global politics that Burns could hardly have dreamed of. Volcker got Ronald Reagan’s offer revolution.
Reagan slashed regulations and broke up the air traffic controllers union in 1981, laying off 11,359 air traffic controllers in one go. Volcker saw this as a “decisive” moment in the battle against spiraling wages and prices. There has also been a surge in low-tax-incentive investment in the United States, alongside a much-needed productivity boom. Add to all this the eventual oil price crash of 1986, the dawn of globalization and the beginning of the computer age, and you get the picture: Volcker was lucky.
This story matters. Look at the environment in which current Fed Chairman Jay Powell operates and you might wonder how he can be a Volcker without the luck of Volcker. A low-tax, low-regulation productivity boom under President Joe Biden seems unlikely. There is no room for a new wave of globalization and, with the US labor market still very tight, the risk of a spiral in wage prices (not unjustified) remains very high.
If you’re using the 1980s as a benchmark for how quickly inflation can be brought under control by smart central bankers, you might want to keep the lessons of Volcker and Burns in mind. The success of central banks is more a matter of luck than skill.
Outside the United States, you might also want to keep a close eye on British Prime Minister Liz Truss. There’s something Reaganomics about the tax cuts, regulatory tearing, productivity pumping rhetoric his government is proposing – as demonstrated in Friday’s mini-budget unveiled by Chancellor Kwasi Kwarteng . The Bank of England may be about to get lucky.
None of this particularly helps us to know where inflation will end up: since most forecasts have proven wrong so far, we must, I fear, ignore most forecasts. But the fact that we can’t know helps us a bit with our investments – in that it should remind us that we need to build in some insurance. It’s almost impossible to do in the United States. The S&P 500 is trading on a forward price-to-earnings ratio of around 17x – a little above the historical average at a time when most other things are rather worse than average.
You could say it’s about fair value if you assume interest rates won’t go above 5% and you think in terms of earnings yield. But nothing else quite works: GMO’s current 7-year forecast suggests an annual real return for US equities of minus 1%. Anxiety indeed.
There is, however, one market where things look rather better. The UK, with the help of Trussonomics, is on a 9x forward P/E. Earnings will of course be downgraded, notes JPMorgan, which now sees the UK as its top pick in developed markets. But it still represents a significant “valuation cushion”. Investors should use it.