The writer is the editor-in-chief of Money Week
It’s hard not to feel sorry for Arthur Burns, chairman of the US Federal Reserve, when you look at the unpleasant inflationary years of the 1970s. He clearly felt his failure deeply (and that was a failure – inflation was at 6.5 per cent a year during his tenure) if the title of his 1979 lecture in Belgrade was a must. He called it “the torment of central banks.” It’s a useful read today for any investor wondering where to put their money in an era when inflation is rising again.
The problem, Burns said, is that the Fed “in theory” has the ability to “restrict the money supply and create enough pressure in the financial and industrial markets to end inflation without much delay.”
It did not function two things. First the policy. The Federal Reserve has been “caught in the philosophical and political currents that have been transforming American life and culture”—in particular, the idea that “providing for bad times” is no longer a private responsibility but a public one. Add the post-deficit spending bias to increased regulation across the economy and high taxes that discourage business investment and the result is inevitable: an automatic “inflationary twist.”
Second, monetary policy is very difficult. Contrary to the belief of most central bankers, there is no specific model that works: “Monetary theory . . . does not provide central bankers with simultaneously firm and reliable decision rules,” in the words of Burns. We may know that “excessive creativity of money” will lead to inflation, for example, but this knowledge “does not reach mathematical precision”. Results? Surprises and mistakes at “every stage of monetary policy making”.
Among the audience in Belgrade sat Paul Volcker, the new chairman of the Federal Reserve, and the man now known to do exactly what Burns felt he could only do in the abstract: stamp out inflation. By the middle of 1981, the monetary policy hawk had reached nearly 20 percent interest rates and long-run inflation. By the time he left in 1987, it was nearly 3.5 percent.
A few years later, Volcker gave a lecture entitled “The Triumph of Central Banks?” No wonder today’s central bankers want history to remember them as Volcker, not Burns. But note the question mark in its title. A recent research paper from analysts at Ned Davis Research notes that Volcker had the kind of support from domestic and global politics that Burns could hardly have dreamed of. Volcker had a supply-side revolution for Ronald Reagan.
Reagan cut regulations and broke the Air Traffic Controllers Guild in 1981, firing 11,359 air traffic controllers at once. Volcker saw this as a “watershed” moment in the battle against the wage-price spiral. There has also been a sharp rise in investments with low tax incentives in the US, along with a very beneficial productivity boom. Add to all that the final oil price crash in 1986, the dawn of globalization and the beginning of the computer age, and you get the picture: Volcker got lucky.
This date is important. Look at the environment in which current Fed Chairman Jay Powell operates and you might wonder how Volcker could be without Volcker’s luck. There seems little chance of a low-tax, low-regulated productivity boom under President Joe Biden. There is no room for another explosion of globalization, and with the US labor market still tight, the risks of an (unexplained) wage-price vortex remain extremely high.
If you use the 1980s as a reference point for how quickly inflation can be killed by clever central bankers, you may want to take the lessons of Volcker and Burns into account. The success of central banks is more a matter of luck than skill.
Outside the US, you may also want to keep a close eye on British Prime Minister Liz Truss. There is a bit of Reaganomics in the tax cuts, the shredding of regulations, and the productivity-pumping rhetoric that its government is giving – as made clear by Friday’s mini-budget unveiled by Chancellor Kwasi Quarting. The Bank of England may be about to get lucky.
None of this particularly helps us see where inflation will end up: since most predictions have been wrong so far, I should be afraid to ignore most predictions. But the fact that we can’t know helps us a bit with our investments – it should remind us that we should build up some insurance. It is almost impossible to do this in the United States. The S&P 500 index futures price-earnings ratio is trading about 17 times – just above the historical average at a time when most other things are worse than average.
You can argue that it is only about fair value if you assume interest rates will not exceed 5 percent and think in terms of dividend yield. But nothing else quite works: GMO’s current 7-year forecast suggests an annual real return for US stocks of 1 percent. Really anguish.
However, there is a market where things look somewhat better. The UK, aided by Trussonomics, puts P/E forward 9 times. Profits will be cut, of course, noted JPMorgan, who now considers the UK its top pick in the developed market. But this is still a great “evaluation cushion”. Investors should use it.