Kevin Cousins, Head of Research at PSG Asset Management
The last time developed countries experienced inflation rates as high as recent levels, was 40 years ago at the end of the ‘Great Inflation’, which lasted from 1965 to 1982. Current thinking often paints Paul Volcker (Chairman of the US Federal Reserve (the Fed) from August 1979 to August 1987) as something of a hero responsible for finally bringing high US inflation under control. He is almost regarded with reverence by many economists and policymakers, and is often portrayed as a man willing to do the hard thing for the greater good and despite severe criticism. His actions are also often contrasted with those of his Fed predecessors Arthur Burns (1970 to 1978) and William Miller (1978 to 1979), who are seldom portrayed in an equally positive light.
Given the recent high levels of inflation, it should come as no surprise that policymakers and market participants alike are revisiting the economic history of the Great Inflation. As former White House Economic Advisor Kevin Hassett phrased it on WSJ Opinion “[Jay Powell] doesn’t want to be Arthur Burns, who let inflation get out of control in the 70’s, he understands he has a historic opportunity to be like Paul Volcker…”.
The ruling narrative on why inflation took so long to control in the 1970’s centres on the idea that policymakers allowed ‘inflationary expectations’ of consumers and businesses to become unhinged, and that it was only Volcker’s commitment to hiking rates that brought it back under control. More importantly, this is the key lesson the current Federal Reserve board has taken from history.
But as with many things, simple narratives often hide complex truths: inflation is multi-faceted and complex, a fact not acknowledged by the ‘inflation expectations’ dogma. Looking below the surface and contrary to popular belief, we see signs that both Burns’ and Miller’s actions contributed to bringing inflation under control.
What the Volcker-as-hero narrative ignores, is that the Arab oil embargo of 1973 and the Iranian revolution in 1978 (a key driver of inflation during the period), also exposed the US’s energy vulnerability. Between 1970 and 1978, US oil production declined by some 2 million barrels per day (bpd), or roughly 20%. Over the same period, imports rose some 5 million bpd. US dependence on imported oil increased from 10% in 1970 to 45% in just 8 years. The increasing cost of oil imports had a huge impact on inflation and the economy – and supply constraints and subsequent investment in productive capacity, has as large role to play in explaining the inflation experience.
The only solution to supply side constraints on an economy is investment. While the market’s pricing signals will incentivise necessary investment, this can be aided or hindered by monetary policy. Higher real rates make investment more expensive and less likely to happen. Fortunately for the US, both Burns and Miller kept real rates low or negative (as shown by the gap between the black and green lines below), and given the lead times involved, by the time Volcker raised real rates and slowed capex sufficient investment had been made to de-bottleneck the economy. Contrast this with the high real rates as Volcker squeezed the economy in the period post 1981 (wide gap between black and green lines).
US GDP growth, CPI and Fed Funds rate 1971 – 1985
Sources: PSG Asset Management and Bloomberg
We don’t believe it is a coincidence that US fixed investment in equipment and structures hit the highest levels in the 75 years of data we have toward the end of the ‘Great Inflation’. Investment in the US swelled across the board, including both upstream energy capacity expansions, most notably the newly developed Alaskan fields, and downstream investment that resulted in a huge reduction in the energy-intensity of the US economy. The combined impact of upstream and downstream investment had a dramatic impact on the proportion of US oil demand coming from imports, when growth recovered in 1984 this had dropped from 45% to the 25% to 30% range. The below chart shows that the growth or decline in imports as a percentage of energy consumption appears to lead changes in the inflation rate.
US Crude Oil Import percentage and CPI 1960 – 1986
Sources: PSG Asset Management, EIA and Bloomberg
In analysing inflation history, we see strong evidence that ‘The Great Inflation’ was in fact resolved by the Burns/Miller investment boom, and Volcker’s rates policy would not have been effective without the prior debottlenecking of the economy. Afterall, inflation is multi-faceted and complex, and there is also a sequentiality to solving an inflation problem – until the supply side bottlenecks are resolved (which can only happen through investment), growth without a speedy resumption in inflation is not possible.
So much for history. Fed Chair Jay Powell has made his intentions clear, and can be expected to keep rates elevated to lower inflation by restraining demand in the economy. However, while the US once again has significant supply side constraints to growth, the levels of investment are near all-time lows and will be further discouraged as rates remain high. Unlike during the ‘Great Inflation, we do not anticipate an investment influx into productive capacity that will help ease inflation, and regrettably, this means any future recovery in growth will be quickly followed by a resurgence in inflation. This outcome is not anticipated by the markets.
Investors have been reaching for the assets that worked previously during the secular stagnation period. However, ‘long duration’ assets such as long-dated treasuries and high PE growth stocks, have historically provided very poor outcomes in volatile inflationary environments. Unfortunately, large parts of the market are still focused on precisely these assets, which dominate global equity indices and hence portfolios. Investors need to accept that a portfolio that will deliver on long-term return objectives in this volatile environment will look very different to indices and benchmark-hugging portfolios.
ENDS
