Typically stocks bottom well after the first interest rate cut, which may take more time than is priced in to markets today.
Given the debt levels, it will be much more difficult to reach the real interest rates levels needed to contain inflation.
“Much worse than the 1970s”
“The assumption that central banks can easily hike rates as they did back in the 1970s has a catch. Take the United States as an example. In the 1970s, US debt/GDP was 30%; nowadays, it is above 120%. And this is just government debt; things do not look better on the business level.”
“The last 5 times US Inflation peaked above 5% it took a much higher Fed Funds Rate and a recession to bring it back down. Is this time different?”
As most investors have never experienced current inflation rates in their investing lifetime it is well worth measuring current conditions against the last period of high inflation rates, the 1970s. The deeper one analyzes the comparison the more troubling the question in the title becomes.
First let’s consider the question Niall Ferguson raises ….
There are many aspects to the comparison between the 2020s and the 1970s. The following headings take us through some of the key factors.
Real Interest rates
The chart below shows the key role real interest rates have had in crushing high inflation rates. The last five times, since 1970, that inflation rose above 5%, real interest rates had to rise above the inflation rate before it came down.
Currently the market is not anticipating interest rates at or above 5%, let alone 8%.
The level of US debt is around four times higher than in the 1970s
Debt has not only contributed to slower growth since the 1970s, it also makes higher interest rates much harder to execute as the scale and burden of refinancing becomes far more painful as interest rates rise.
The chart below shows that debt levels declined in the 1970s, even reaching a low point. They have risen dramatically ever since with a hiccup in the 1990s. This suggests that it may be an enormous challenge for the Fed to raise interest rates sufficiently to contain inflation.
Record Policy Intervention going into the 2020s, despite their poor long term record.
The policy intervention comparison may show another adverse difference in the outcome between the 1970s and 2020s. Intervention was still relatively minor in the 1970s, and debt so much lower. After all, the economy was only just transitioning out of the gold standard which had kept policy intervention limited.
In the 2020s, the intervention scaled new extremes following decades of increases in debt and record low interest rates. This escalated to the “Most Reckless Fed Ever” , which we discussed at the beginning of 2022. This itemized the excessive policy interventions, across the board. These interventions were clearly intentional as they were announced in the BIS annual report in 2019.
So now we see the cost. All these interventions have mainly delivered instability and inflation rather than sustainable growth. Yet, after decades of accelerating intervention, the violence and instability of extreme policy intervention continues. The Fed has switched from its extreme stimulus and “transitory” inflation view of 2021 to the most rapid and aggressive tightening of policy ever in 2022.
No one should be surprised about this dramatic reversal. Political expediency compels policy makers to do something “now”. Nevertheless, It is important to notice that long term growth has been declining for 70 years – as shown in the link above.
This pattern of intervention behavior with poor results is not new. It was observed almost 100 years ago, along with the inevitable consequences, as described in the legendary quote below.
“What generates the evils is the expansionist policy. Its termination only makes the evils visible. This termination must at any rate come sooner or later, and the later it comes, the more severe are the damages which the actual boom has caused.”
Ludwig von Mises
Geopolitical Transformation much more significant than in the 1970s
The link in this title goes to Goldmoney’s in depth analysis of a complicated transformation developing out of this years geopolitical developments. It is likely that these developments are highly significant yet still poorly understood. Here is a summary:
“The trade war against China started by President Trump combined with Putin’s initiative against Ukraine have led to the end of the benign global trade conditions that evolved since the 1980s. The combination of rising interest rates and the permanent collapse of global supply chains is the result of policies originated in the west.
The political class appears unaware of the importance of these developments. We see no evidence of sufficient competence in their economic advisers either. While some intelligence analysts may be vaguely aware of the importance of these trade developments, we cannot be sure in these days of group-thinking that they would be listened to.
These long-term trends tend to be understood, if they are at all, in retrospect. Politicians will pursue policies which they believe worked yesterday in changed conditions with catastrophic results. Both they and central bankers have dismissed the link between the expansion of currency and a fall in its purchasing power. Because dollars were bought by foreigners, the dollar was supported, giving rise to an illusion that the quantity of money has little or nothing to do with the inflation of prices. That is no longer the case. And if, as seems certain, the response to contracting bank credit and continuing supply chain failure is to reopen the currency spigot, there will be a rude awakening as to the inflationary consequences.“
The inflation consequences are likely still underestimated
There is a range of high quality research on the most likely outlook for inflation longer term. On current settings there is significant doubt about whether inflation will fall to the Fed’s 2% target in the next two years, without a severe downturn.
The Brookings Institute research shown below states:
“If either the labor market doesn’t behave, or expectations don’t behave, the small increase in unemployment the Fed projects won’t be enough.”
Consider Fed Chair Powell’s comments from earlier this week:
“History cautions strongly against prematurely loosening policy. I can assure you that my colleagues and I are strongly committed to this project and we will keep at it until the job is done.”
Niall Ferguson did us all a favor in challenging the complacency of a quick and effortless return to 2% inflation. All this year I have remarked that getting Fed funds above the inflation rate is an enormous challenge for the Fed.
The interest rate hiking challenge is likely to take longer than most expect, if the Fed is really serious about containing inflation. Beyond that it may be some time before interest rates can be reduced.
This will likely be a considerable challenge for equities as the chart below shows that equities typically hit a bottom only well after the first interest rate cut, which could be more than a year away.
Just focusing on the comparison with the 1970s indicates a challenging decade ahead for growth and inflation. Investors need to be prepared for tough conditions with the highest possible standards for Investment Management.
If you’re not already a client of CB Investment Management, schedule a FREE consultation today. Let me use my expertise and proven track record to prepare your portfolio for the tough conditions ahead and transform you to a Best Investor.
Please note these important disclaimers: Educational use Only. The market update published by CB Investment Management, LLC (“CB Investment”) is intended to be educational in nature and is not intended to be a recommendation for any specific investment product, strategy, plan feature or other purposes. Accordingly, it should not be construed by any consumer and/or prospective client as solicitation to effect, or attempt to effect transactions in securities, or the rendering of personalized investment advice for compensation.Advertising and Marketing. Communications such as this are not impartial and are provided in connection with advertising and marketing. This material is not suggesting a specific course of action or any action at all. Prior to making any investment or financial decisions, an investor should seek individualized advice from a personal financial, insurance, legal or tax professional that takes into account all of the particular facts and circumstances of an investor’s own situation. No person associated with CB Investment is a licensed attorney or tax professional and the information contained herein should not be considered tax or legal advice. Links to Third Party Content. This Market Update contains links to articles or other information maintained by unrelated third parties. You acknowledge and agree to the following: All such information is provided solely for convenience purposes only because we believe that it may provide useful content and all users thereof should be guided accordingly. We disclaim any responsibility for the link’s performance or interaction with your computer, its security and privacy policies and practices, and any consequences that may result from visiting it. We do not control the content published by the third-party; we do not guarantee any claims made on it, nor do we endorse its sponsor or any of the content, policies, activities, products or services offered by any advertiser on the site. CB Investment assumes no liability for any inaccuracies, errors or omissions in or from any data or other information provided by the third party and inclusion or reference by CB Investment to any third party link should not be construed by any consumer and/or prospective client as a solicitation to effect, or attempt to effect transactions in securities, or the rendering of personalized investment advice for compensation, over the Internet.
Important Information regarding Registration Investment advice is offered through CB Investment Management, LLC (“CB Investment”), 8231 Crestwood Heights Drive, Mclean VA 22102 an investment adviser registered with the states of Virginia and Maryland. Registration with the states of Virginia and Maryland should not be construed to imply that the SEC has approved or endorsed qualifications or the services offered, or that its personnel possess a particular level of skill, expertise or training. Important information and disclosures related to CB Investment are available at https://chrisbelchamber.com.