An Evidence-Based Look At Inflation, Recessions And Pivots, Part Two
By Daniel R. Amerman, CFA
TweetThere are a lot of theories out there about what will happen with interest rates, inflation and a recession in 2023. If we look at the strongly inverted yield curve for Treasury securities, with the 10 year Treasury currently yielding about 1.4% less than the 6 month Treasury, this means that the bond market is anticipating that a recession will force the Federal Reserve to "pivot", and to slam interest rates back down to escape the recession. This sharp and fast reduction in interest rates would produce very large profits for medium and long-term bond investors (link here).
If we look at the DJIA, Nasdaq and S&P 500, they are all up sharply from their levels in October. To have stock prices rising fast even as a recession is viewed as increasingly likely is an interesting phenomenon. The most common explanation is that the markets are pricing in expectations for a short recession that will finish off inflation, and will allow a return to much lower interest rates on an ongoing basis.
There is, however, an issue with the market expectations. As explored in Part One of this analysis, this same theory of using high interest rates to fight inflation, that then leads to a recession that stops inflation, and which then allows a pivot - a rapid reduction in interest rates - was a popular theory in between 1968 and 1980 as well. In fact, it was so popular that it was attempted three times. In practice, the combination of recessions and pivots didn't work even once, instead inflation eventually ended up just getting higher after each painful attempt.
In this Part Two, we will closely examine how the Paul Volcker Fed was able to finally break the back of inflation and bring the 1968 to 1983 secular inflationary cycle to an end. We will find that there were four critical components that separated the successful fourth attempt from the three previous unsuccessful attempts. We will then contrast this with the current Federal Reserve attempts to end our new inflationary cycle - and find that what the Fed is planning is zero out of four, it is not planning on using any of the four historically proven critical components (or if it is, it's not telling anyone and the markets are not expecting it).
This analysis is part of a series of related analyses, which support a book that is in the process of being written. Some key chapters from the book and an overview of the series are linked here.
1968 To 1980
Part One of this analysis is linked here, and it highly recommended that it be read first, if you have not yet done so. Our current situation of the Federal Reserve using interest rate increases to try to bring down inflation even at the risk of triggering a recession is not new, it has happened many times before - and we have that history.
As reviewed in Part One, Fed Chairs Bill Martin, Arthur Burns and William Miller had all faced inflationary pressures, with sources including the deficit spending that funded the Vietnam War, as well as the Oil Embargo of late 1973 and early 1974.
As shown in the graph above, they all tried "reasonable" methods of using interest rates to knock down inflation, without inflicting excessive economic damage. When the red line of inflation was climbing, they increased the yellow line of interest rates until a recession started. They then quickly reduced interest rates (producing large bond market profits) in order to pivot and get the economy out of recession.
This can be seen with the two big spikes in the yellow line of interest rates, which then quickly went the other direction. In each case, an annual average real (inflation-adjusted) interest rate of a little over 2% was produced. This then created disinflation each time, as the rate of inflation came down. It never, however, broke the wage/price cycle, even long after the original sources of the inflation were gone.
This continuing inflation can be seen with the two reversals, where the disinflation would bottom out - and then the red line would start climbing right back upwards. Each time this happened, there was a new and higher inflationary base.
What is sometimes forgotten is that there was a third attempted pivot, which was Paul Volcker's first attempt as Fed Chairman. Appointed with a mandate to do what it would take to wipe out inflation, Volcker came in much more aggressively than any of his predecessors and raised the Fed Funds interest rate to over 17%. Mortgage rates briefly spiked up to over 16% as the housing market went into crisis. This created broad market mayhem and also quickly produced a new recession.
Volcker then attempted what could be called a finesse, using the best of the economic theory that had been developed in the previous twelve years of (unsuccessfully) fighting inflation. He pivoted harder than any Fed Chair before, slamming interest rates down by 8.5% in just three months. The pivot worked when it came to the economy, with the economy quickly coming out of recession. There was, however, a problem - the 12 month rate of inflation was still at 12.9% in August of 1980, which was higher than before he started. Many millions of people had lost their jobs - including their homes and savings for some - the markets had been pummeled, and all for nothing, as inflation was now destroying the value of the dollar faster than ever. (This was the end of Part One.)
Going Medieval On Inflation
Thirteen years of being reasonable and finessing hadn't worked, the situation just kept getting worse, so Volcker (and the voting members of the FOMC) decided to become unreasonable, and to go after inflation with a sledgehammer until they vanquished it.
Volcker pushed rates up to almost 19% by December of 1980, about 10% above their July floor. This created real interest rates of over 6% when compared to inflation, which was 2X to 3X of the much more "reasonable" 2% - 3% peak real interest rates of previous cycles with Bill Martin and Arthur Burns. As a result, the economic recovery was cut short, and the United States was back in recession by July of 1981,
This next part is the most important part when it comes to 2023 and 2024 - Volcker did NOT pivot. Unlike every previous cycle, he did not attempt to escape the recession, but just left the recession and very high interest rates in place, trying to choke off the inflationary cycle.
It wasn't instantaneous, but Volcker created a steady disinflation. He then rode the disinflation down - a very different strategy from pivoting. He never slammed rates down to escape recession, but instead lowered interest rates only as inflation itself was slowing down, while still keeping steeply positive real interest rates, i.e. Fed Funds that were much higher than the rate of inflation.
The difference between pivoting and riding the disinflation down is visually obvious. The unsuccessful strategy of the pivot can be seen on the left side of the graph, as the yellow line of interest rates was forced sharply below the red line of inflation, which moved the green line of real interest rates into negative territory. With no pivot, the yellow line of interest rates slowly declines, but only as the red line of inflation is falling as well, the green line of real interest rates remains strongly positive. By the time interest rates were moved below 10% in 1982 - inflation was under 5%. This is in stark contrast to the pivot in 1980 where interest rates were sent below 10% even as inflation was still above 14%.
This was a very painful time for the nation, with a deep recession that lasted until November of 1982. That said, it (finally) worked. Following the red line, 24 months of disinflation brought the rate of inflation down from 12.4% in December of 1980, to a 3.8% rate by December of 1982, a month after the recession ended.
Volcker wasn't about to stop there - he wanted to make sure that the wage/price spiral had been crushed for good - and as we can see if we follow the green line, he actually increased the real rate again, even after having gotten inflation under 4%. By August of 1983, four years into his term, Volcker had forced inflation down to an annual rate of 2.5%, which was the lowest rate that the United States had seen since 1967.
This same information can be seen in a smoothed annual form in the graph above. Under the leadership of Burns and Miller through 1976, 1977, 1978, and 1979, the green line of real interest rates was near zero or slightly negative - and the red line of inflation climbed every year, long after the end of the original sources, the Vietnam War and the oil embargo. In comparison, today we still have extraordinary levels of deficit spending, we still have the Ukraine War, we still have global energy turmoil - and even after the December 2022 rate hike, our current real interest rate is negative 2.4% (monthly average Fed Funds Rate less 12 month CPI inflation). It is off the bottom of the scale above.
Volcker's first attempt in 1980 was a failure, as the pivot canceled out his brief 17% interest rate sally, and a near zero average real interest rate for the year led to an annual average rate of inflation of 13.5%, the highest of the entire secular inflationary cycle.
The breakthrough occurred with Volcker's second attempt in 1981, when an average interest rate of 16.4% knocked inflation down to an annual rate of 10.4%, with the real interest rate exploding upwards to +6%. Even with the economy in recession, there was no pivot, and if we look at the constant spread of the yellow interest line above the falling red inflation line, we can see exactly what Volcker was doing. Volcker was riding the disinflation down, and on an annual average basis the green line of real interest rates was kept at an almost perfectly level 6% for four straight years, and then close to 6% for another two years after that. This is what finally broke the wage/price spiral, and what finished off the secular inflationary cycle.
The Taylor Rule
The most recent 12 month Consumer Price for December of 2022 came in at a 6.5% rate of inflation. This is a mild degree of disinflation, that has been fed by recent decreases in energy prices. Nonetheless, the 6.5% rate of inflation would have still been the highest rate in four decades on its own (since June of 1982), if inflation rates had not been still higher recently.
What is particularly problematic is that the core rate of inflation - exclusive of food and energy - rose at a 5.7% annual rate, after rising at a 6% rate the previous 12 months. What has been happening is that we've been seeing deflation with fuel and auto prices in the last few months, which when averaged in with all other prices is producing disinflation, a reduction in the rate at which the rate of prices are increasing. So, if we take away changes in oil prices and natural gas prices, then we still have broad-based inflation that is loose in the economy.
This moderate disinflation primarily driven by energy costs is being presented by the media and some of the markets as cause for great optimism, and as a reason to stop the interest rate increases. As covered in the previous analysis, removing the sources of the original inflation while still having established core inflation of around 6% is nowhere close to a victory over inflation, but rather the opposite. (For those with memories and eyes to see, we've seen this movie before, as explored in Part One.)
The lessons of the 1968 to 1983 secular inflationary cycle were the subject of intense academic scrutiny for decades afterward. As explored in more depth in my much more thorough analysis last spring "Rising Inflation, The Taylor Rule, Rational Bubbles & The Fatal Flaw" (link here), by 1993, a Stanford professor named John Taylor proposed what is today called the Taylor Rule. This rule reflected the prevailing academic beliefs that while Volcker was ultimately successful, the inflation of the 1970s and early 1980s was mishandled. The blows did not have to be so extreme, and they should have taken place much earlier.
The Taylor Rule is explained in more detail in the linked analysis, but if we leave aside output, then the interest rate to control inflation is the sum of the natural interest rate, current inflation, and one half of the gap between the target inflation rate and the current inflation rate. So, if the natural interest rate is 2%, the current inflation rate is 6.5%, and the target inflation rate is 2%, then as shown in the graph above a Fed Funds rate of 10.8% is the correct starting point if inflation is to brought back down to 2%. (2% + 6.5% + (.5 * (6.5% - 2%)) = 10.8%.)
If we look at current economics textbooks, then the Taylor rule is still there as being the best available macroeconomic technique for bringing down inflation. So, if we just follow the Volcker experience for what worked in the real world, then the Fed Funds rate should currently be inflation plus 6%, or 12.5%, and that 6% spread above inflation needs to be in place for multiple years to come. Conversely, if we use the more refined Taylor Rule, we can get away with only raising interest rates to 10.8%, and then riding the disinflation down, with interest rates falling at a slightly faster rate than the decreasing rate of inflation.
The other key point from thirty years ago, after economists had had ten years to study to inflationary cycle of 1967 to 1983, is that the central bank should be very quick in decisively reacting to inflation. All those years of Martin, Burns, and Miller trying reasonable sounding half measures to avoid pain in the short term were just causing unnecessary pain over the long term, as inflation became ever more entrenched and the nation endured repeated recessions that didn't cure the problem.
With 20/20 hindsight, it was (effectively) agreed that Fed Chair Martin should have come in fast and hard in the late 1960s, creating steeply positive real rates, accepting that single recession, and choking off the new inflationary cycle by 1968 or 1969, before it had time to get fully established. The 1970s and early 1980s could have been a time of low inflation, economic growth and prosperity for the entire nation.
What Is Actually Being Done Today
There is a lot of controversy over what the Federal Reserve is currently doing, with many saying that Powell is being much too harsh, and unnecessarily inflicting too much damage. To get some perspective, let's compare what Powell is doing today to what happened in the 1967 to 1983 secular inflationary cycle.
1. Reaction Time. As I was writing about by May of 2021 (link here), the 12 month April CPI that was released in May, was enough to establish that we were in a new inflationary cycle that was not transitory. Remembering the past, this is what I wrote as part of that analysis:
"What was once well understood among economists seems to have been (conveniently) forgotten and wished away, leaving only a misplaced veneer of confidence. It isn't just the cost of fuel and the cost of vehicles that are the issues. It is the increases in prices that eventually follow for everything that is transported by vehicles that use fuel. Because this changes so much of the costs of the standards of living for everyone, the cost of labor must then rise as well - which wraps back around to increasing the cost of producing all supplies, which then leads to yet another round of wage increases. This is simple history, it can be a very difficult cycle to break - and it is also what we have right now, simultaneous supply and labor shortages in a number of industries. Once the genie is truly out of the bottle, what history shows is that putting inflation back into the bottle is not necessarily transitory at all."
While it is in the same format as previous graphs, the graph above shows how the Federal Reserve has reacted to inflation over the last two years in a radically different way than it ever did in the 1960s to the 1980s.
The rolling 12 month rate of inflation reached 4.1% by May of 2021, the highest seen since 2008. In contrast to the vigilant Fed of 1968, the current Fed insisted that the inflation was transitory - it did not want to have to deal with high rates of inflation by raising interest rates. The current Federal Reserve ignored inflation for months while hoping it would go away on its own. The Powell Fed did not react by raising rates until ten months later, March of 2022, by which time the unchecked inflation had reached 8.7%. The Fed did not increase its average monthly interest rates by 2% until August of 2022 - which was a 17 month lag.
There was an almost glacial slowness of the reaction to the red line of rising inflation. In contrast, history shows that Fed Chairs Martin, Burns and Volcker would have all likely seen the same thing I did in May of 2021 – close to two years ago - as explained in the analysis I published that month. They would have likely been reacting in real time. When I made that call - which was in stark contrast to the contemporary prevailing narrative presented by the Fed and the financial media - I wasn't coming up with anything new, I was just presenting the mainstream economic viewpoint for anywhere in the 1960s and 1980s, the last time we had major inflationary issues.
If we compare to the previous cycle, the 12 month inflation rate jumped to 4% in February of 1968, the highest seen since 1952. Bill Martin's Federal Reserve had very carefully tracked the uptick in inflation every step of the way and had begun raising rates the preceding November, as inflation moved from 2.4% to 2.7%. The Fed increased the average Fed Funds rate for seven straight months, and by May the rate was 6.1%, which was 2.2% higher than the 3.9% rate of inflation for that month. The Fed was aggressively raising interest rates in real time, trying to stay ahead of inflation.
We can also see this instant and major reaction when inflation began to rebound in 1973. The rolling 12 month inflation rate jumped from 3.4% in December of 1972 to 3.9% in February of 1973. The Arthur Burns Fed instantly reacted, boosting the average monthly Fed Funds rate by 1.25%, from 5.33% to 6.58% in those two months. Even though Burns is still remembered today for being weak on inflation, he would then raise Fed Funds rates by another almost 4% by July, moving interest rates up to over 10% in an attempt to preemptively contain inflation that had risen to an annual rate of 6%.
Powell and the current Fed are no Volcker, they are instead much more like William Miller - only in exaggerated form - refusing to raise rates while closing their eyes and hoping the inflation would go away on its own.
Despite all the screaming, wailing and gnashing of teeth from the markets that the Fed is moving far too fast and aggressively, it's actually moving at an extraordinarily slow and timid pace, when compared to the last round of comparable inflation. And even the comparatively aggressive pace of 1968 was far too slow and timid, as economists would later agree with the benefit of 20/20 hindsight.
2. Real Interest Rates.
The Federal Reserve held rates at near zero percent (the yellow line) in 2021 and early 2022, as inflation went above 4%, 6% and 8%. This then created unprecedented real (inflation-adjusted) interest rates of -4%, -6% and -8%, as can be seen with the green line.
Wealth was being pulled out of the nation's bank accounts at an unprecedented rate, as bank depositors were being paid nothing while the value of their money was falling at an 8% rate. As explored in my book "The Stealthy Raid On Our Bank Accounts" (free first chapter link here), what the Federal Reserve has been doing is using the purchasing power of the money in our bank accounts to keep interest rates artificially low, so that our savings are being used to deprive the nation of the value of our savings.
What we see with the negative real rates was upside down when compared to the 1968 to 1983 period. Strongly positive real interest rates were created whenever inflation was rising, in an attempt to create disinflations, reductions in the rate of inflation. Negative real interest rates were used only in the very specific context of pivots, when the Fed would try to "juice" the economy with very low interest rates and move it out of recession.
The 2020-2022 Federal Reserve has been doing the direct opposite. By refusing to raise interest rates for a long period of time, the Fed created the largest negative interest rates we have seen to date. What economic history shows is that negative interest feed inflation, they don't diminish inflation.
This feeding and acceleration can be seen in the speed with which the rate of inflation jumped from 4% to 6% to 8%. In the previous cycle, when the Fed was seriously trying to fight inflation, it took 19 months - June of 1968 to January of 1970 - for inflation to rise from 4% to 6%. In contrast, with the Fed feeding the inflationary fire with steeply negative real rates in 2021, it only took 6 months, from April to October.
When the Federal Reserve was using positive real rates, it took 5 years and 5 months, from June of 1968 to November of 1973, for inflation to rise from 4% to 8%. The modern Fed's refusal to acknowledge reality meant that it only took 10 months for inflation to jump up from 4% to 8%. Refusing to raise interest rates meant that inflation was increasing at 6.5X the rate in 2021 and 2022, compared to the 1968 to 1973 period.
A month after the 12 month inflation rate reached 8%, the Federal Reserve finally did begin to increase interest rates. We are now (thankfully) seeing a modest degree of disinflation, and many are saying that now the battle against inflation is over, the job has been done. Unfortunately, that is not what history shows. There were numerous periods of disinflation in the previous secular inflationary cycle, and only the last one meant that inflation had been vanquished.
This is particularly the case when we examine the recent real rate for December of 2022, comparing the monthly average Fed Funds rate to the 12 month rolling CPI, shows a negative 2.4% real interest rate. Historically, at that level - that should increase inflation and not decrease inflation, all else being equal.
Zero Out Of Four
The United States is currently experiencing what is by far the highest and most persistent inflation that it has seen since the 1968 to 1983 secular inflationary cycle. There are a lot of theories and strategies that are being offered for what to do about this.
What the markets are expecting for 2023 then, is that the Fed will continue to increase interest rates, to the highest levels seen in recent years - but nowhere near some historical levels. Inflation "hawks" seem to be talking about Fed Fund rates in the 5% to 6% range when they are done, or roughly 1% to 1.5% higher than where we are currently. No one in a position of power seems to be anticipating even a small chance of rates going above 10%.
The other major market expectation is that the United States will only experience interest rates at current or higher levels for a relatively brief period of time, and that a recession in 2023 will lead to a pivot in 2023, with interest rates being slammed downwards to escape the recession.
Let's compare this to what we learned in the 1968 to 1983 era about how to actually beat high and persistent inflation. The combination that worked is the following.
1. Moving quickly to keep inflation from getting established.
2. Using strongly positive real rates, interest rates well above the rate of inflation.
3. Keep the strongly positive real rates in place for multiple years.
4. No pivot during recession.
If we look at what the Fed has done so far, and what the markets think it will do over the next year, then we get the following plan.
1. The Federal Reserve moved very, very slowly, letting inflation get established.
2. The Fed is still using steeply negative real rates, with inflation above interest rates.
3. Even the current rates are expected to last less than a year.
4. The Fed is expected to pivot hard when a major recession hits, creating another round of deeply negative real interest rates in an attempt to stimulate the economy.
When we compare the two lists, what worked before to what the Fed is expected to do this time, then we find the current plan is zero for four.
The Fed is not expected to repeat even a single item from the list of what actually worked. Instead, the Fed will make the single weakest attempt at beating inflation to date.
A Compounding Series Of Mistakes
If we use history as our guide, then the chances are good that the Federal Reserve is in the process of making a mistake of historic proportions. It is creating market havoc with its interest rate increases, particularly in the housing market. It is likely to trigger a recession that will be very painful for the nation - and the markets. While this is likely to create disinflation, the historical evidence is still fairly clear that this probably will not be enough to break the wage/price spiral that the Fed's slow and timid actions have allowed to get started.
We've seen this movie three times before, where "reasonable" half measures are taken - with the end result being that there is a great deal of financial and economic pain, and then the inflation returns.
There are some very important implications for long term investment strategies.
While we can never know the future for sure, the Federal Reserve's very weak attempt at inflation control substantially increases the chances that we will be entering into another secular inflationary cycle.
Such a long-term cycle can be savage for some of the most popular investment strategies of recent decades. At the same time, we may be seeing unusually good times for other types of assets, for contracyclical assets and strategies.
Fortunately, we not only have an extensive history with regard to attempts to contain inflation, but we also know in great detail how the different basic investment categories performed in each period. We can track precisely how stocks, bonds, precious metals and real estate performed over the secular inflationary cycle, as the Fed repeatedly created recessions while failing to stop inflation.
For most people - this is long-forgotten investment knowledge, along with the names of Bill Martin, Arthur Burns, William Miller and Paul Volcker. This past is, of course, unlikely to exactly repeat itself. The world of the 2020s is very different from the world of the 1970s. But, there is nonetheless great value in at least understanding the investment lessons of the past, when preparing for an uncertain future.
One lesson, as explored in the analysis linked here, is that the most popular long-term retirement investment strategies may fail. Most financial plans do not properly take secular sequence of returns risks into account, and this means that they are prone to failure, as an analysis of the late 1960s through early 1980s shows.
Another lesson is that if inflation is what is ahead - join it, don't fight it. As explored in the first chapter of "The Homeowner Wealth Formula" (linked here), the long-term inflation of the 1970s and 1980s created one of the best markets in history for owning homes, whether as owner-occupants or as rental properties. The multiplication of inflation is one of the very best ways to benefit from a secular inflationary cycle.
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So, how did stocks and gold perform over the multiple recessions and pivots of the 1969 to 1983 era, and what are the lessons for today? As with inflation itself, while the detailed historical information is there, it could be called forgotten lore at this point. I've done the detailed historical research over the course of a number of years, it is fascinating, very few people understand it today, and the results can be found in the online financial education video series "Gold Out Of The Box, 2020s Edition" linked below.
OnLine Videos (Free Trailer At Top)
Changes in secular investment cycles can be financially devastating or wildly profitable - and this can be true on both ends of the cycles. As developed in the educational videos, stocks and gold have over the long term been contracyclical assets, switching back and forth, with one asset in the ascendency and highly profitable, while the other is in a deep real (inflation-adjusted) secular bear market. Until they switch again.
One use of this information is for speculation. However, with full understanding, there is another and much rarer use, which is for risk reduction in inflation-adjusted terms. Stocks and gold have each historically acted as inflation hedges, that are most effective at different times. Once the performance of each asset relative to the other in secular cycles is understood, then rebalancing strategies, ratio strategies, and ratio rebalancing strategies can all be used to capture the ability to come out ahead of inflation, while historically stripping out the risks that come from being in the wrong asset at the wrong time. This can be market neutral, or it can be skewed, with the intention of favoring one asset while trying to minimize the risk if the wrong call is made.
As is always the case with investments, past performance will not necessarily be repeated in the future, and the videos are of an educational nature rather than any form of investment advice. With that being understood, there is no better time to understand what the past has to show us, than early in the potential emergence of another secular inflationary cycle.
This detailed historical analysis of dangers and potential opportunities can be found in the online videos.
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