Central bankers fighting inflation need good political fortune as well as skill

The author is editor-in-chief of Money Week

It’s hard not to feel sorry for Arthur Burns, the Fed chairman, as one looks back on the uncomfortable inflationary years of the 1970s. He clearly felt his failure deeply (and it was a failure – inflation averaged 6.5 percent a year during his tenure), if one can reasonably understand the title of a lecture he delivered in Belgrade in 1979. He called it “The Anguish of Central Banking”. It is useful reading today for any investor wondering where to put their money at a time when inflation is rising again.

The problem, Burns said, is that the Fed has “in the abstract” the power to “constrain the money supply and create enough tension in financial and industrial markets to end inflation on short notice.”

That this was not the case was due to two things. First, politics. The Fed was “embroiled in the philosophical and political currents that were transforming American life and culture” — particularly the idea that “preparing for bad times” was no longer a private but a public responsibility. Add the consistent focus on deficit spending to the increase in regulation across the economy and the high taxes that deterred business investment, and the result was inevitable: an automatic “inflationary turn”.

Second, monetary policy is very delicate. Contrary to what most central bankers believe, there is no definitive model that works: “Monetary theory . . . does not provide central bankers with decision-making rules that are both fixed and reliable,” as Burns put it. We may know that “excessive money printing,” for example, causes inflation, but that knowledge “recedes mathematical precision.” The result? Surprises and mistakes at “every stage of monetary policy”.

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Among the audience in Belgrade was Paul Volcker, the new Fed chairman and the man now known for doing what Burns believed he could only do in the abstract: fight inflation. By mid-1981, the tough man of monetary policy had interest rates approaching 20 percent and inflation in the works. When he left her in 1987, she plummeted 3.5 percent.

A few years later, Volcker gave a talk entitled “The Triumph of Central Banking?”. No wonder today’s central bankers all want history to remember them as Volcker, not Burns. But note the question mark in its title. A recent paper by analysts at Ned Davis Research indicates that Volcker had the kind of domestic and world political support that Burns could hardly have dreamed of. Volcker had Ronald Reagan’s supply-side revolution.

Reagan cut regulation and broke the air traffic controllers’ union in 1981, firing 11,359 air traffic controllers in one fell swoop. Volcker saw this as a “turning point” in the fight against the wage-price spiral. In addition to a very helpful productivity boom in the US, there has also been a sharp rise in investment with low tax incentives. If you combine all this with the oil price crash of 1986, the beginning of globalization and the beginning of the computer age, you get the picture: Volcker was lucky.

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This story matters. Look at the environment in which current Fed Chairman Jay Powell operates and you may wonder how he can be a Volcker without Volcker’s luck. There seems little prospect of a low-tax, low-regulation productivity boom under President Joe Biden. There is no scope for further globalization pushes and with the US labor market still very tight, the risk of a (not unjustified) wage-price spiral remains very high.

If you’re using the 1980s as a reference point for the speed at which inflation can be smothered by savvy central bankers, you might want to keep the lessons of Volcker and Burns in mind. Central bank success is a matter of luck rather than skill.

Outside the US, you should also keep an eye on British Prime Minister Liz Truss. There’s something of the Reaganomics in the rhetoric your administration is offering on tax cuts, regulatory ruptures and productivity gains — as demonstrated by Friday’s mini-budget unveiled by Chancellor Kwasi Kwarteng. The Bank of England could be lucky.

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None of this helps us much in knowing where inflation will end up: unfortunately, since most forecasts so far have been wrong, we have to ignore most forecasts. But the fact that we can’t know helps us a little with our investments – in that sense it should remind us to build insurance. That’s almost impossible in the US. The S&P 500 is trading at an expected price-to-earnings ratio of about 17 times — slightly above the historical average at a time when most other things are just below average.

One could argue that it’s only fair value assuming interest rates won’t go above 5 percent and thinking about earnings yields. But nothing else is working quite well: GMO’s latest 7-year forecast points to a minus 1 percent annualized real return for US equities. agony indeed.

However, there is one market where things are looking a little better. The UK has a 9x forward P/E using Trussonomics. Earnings are of course downgraded, notes JPMorgan, which now sees the UK as their best bet for developed markets. However, this still represents a significant “valuation cushion”. Investors should take advantage of it.

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