Make America Inflate Again

Our main contention here is that this era of price stability will soon be at an end. And this is unlikely to be just a US phenomenon. We are on a journey to a more inflationary future, one that began long before the financial crisis in 2008. Somewhat counter-intuitively, this journey will first lead us into another deflationary slump. It will be the political response to that slump which breaks the existing regime. This rupture will involve a radical shift in the aims and instruments of macroeconomic control, including a challenge to central bank independence. More broadly, it will threaten the liberal, multi-lateral world order that has underpinned the global economy’s advance since the inflationary quagmire of the 1970s.

The economic, political and market environment today is different in many important respects from that of 50 years ago. But there are also eerie similarities with the second half of the 1960s, when the foundations of post-war stability were undermined. It was the cyclically-driven upswing of US inflation beginning in the middle of the decade, and the Fed’s failure to lean against it, that undermined the dollar’s link to gold. By the time of the Nixon shock in 1971, the breakdown of the existing regime was in train: inflation was already embedded in the fabric of the US economy. As such, both the 1973 spike in oil prices and Nixon’s annexation of Arthur Burns’ Fed a year earlier are best seen as triggers, not underlying drivers, of the subsequent economic chaos.

It is only with hindsight that we can appreciate the critical role of policy failings in the 1960s. But even now it is unclear exactly why inflation took off when it did – and with such force. Modern economic theory assumes inflation rises slowly and linearly once an economy moves beyond full employment. The historical record suggests this may be true within a regime of low and stable inflation. But it is manifestly not how inflation behaves when the existing inflation regime is breaking down, as happened in the 1960s.

In practice, economists know surprisingly little about what drives inflation. Milton Friedman taught us that “inflation is always and everywhere a monetary phenomenon”.³ In one sense, he was spot on: sustained periods of high inflation are the product of unsustainably rapid monetary growth. In another sense, though, his dictum has been a distraction.⁴ In the era of inflation targeting, monetary forces have proved to be a poor guide to inflation dynamics.⁵

This inability to forecast inflation, and possibly even understand its dynamics ex-post, has altered how central bankers behave in two key ways. First, when making forecasts and setting policy, central banks now give far greater weight to current developments in price and wage inflation. Second, by reducing the perceived dangers of low unemployment (until there is clear evidence of its effect in wage growth). Because inflation has persistently surprised to the downside and pay growth has remained contained, a future period of above-target inflation has been viewed as low risk, while the dangers of depressed inflation have been amplified.

Shifts in the inflation regime go hand-in-hand with economic disruption. They cannot be disentangled from the political dynamics of the day.

Long gone, it would appear, are the days of “long and variable lags”, where central bankers would look to normalise policy before the economy had reached full employment. They may not be willing to wait until the “whites of inflation’s eyes” become visible (as Larry Summers suggested in 2015) but policy has become highly reactive to past inflation and wage growth. Persistently sub-par inflation has given the upper-hand to the so-called doves in all the major central banks. And it has provided ammunition for those arguing that policymakers should press hard on the accelerator, until there is categorical evidence that inflation is returning to target. Indeed, this is the explicit strategy of the US Federal Reserve under Jerome Powell.⁶

The Federal Reserve is now withdrawing stimulus and looks set to go further in this cycle. Powell’s Fed may be less dovish than Janet Yellen’s but it is still treading carefully. Short-term real interest rates are around zero, far below historic norms; and, if at all, they will only rise gradually. To anyone with a broad view of economic history, it will seem remarkable that US interest rates are so low (and the Fed’s balance sheet so bloated) in the context of sizeable fiscal stimulus and an unemployment rate just shy of its 50-year low. History would suggest that by now in the cycle one would want macroeconomic policy to be restricting growth.

We have been here before, in the late 1960s. While the reasons have differed in each cycle, the Fed has systematically failed to engineer soft-landings in the post-war period. Policy has moved too little, too late. On some occasions, the cycle has been brought to an end because of rising inflation. On others because of financial excess. Repeatedly, the brakes have been applied hard and fast, late in the cycle, long after economic imbalances have emerged.

Once again, the Fed is underestimating the danger of an overheating economy. A tightening of financial conditions is necessary to slow the economy. That the Fed appears to be blinking (hesitating to tighten further) is telling. It once again reiterates central bankers’ overwhelming fear of the deflationary ditch and the asymmetry at the heart of monetary policy.

This matters because Fed guidance about inflation and the path of interest rates anchors financial markets. Little wonder then that investors attach little weight to the possibility of even a limited burst of above-target inflation. Yet, we have an openly protectionist US president. Leading an administration now devoid of its moderate, globalist faction. An administration that is loosening the fiscal reins at a time of still supportive monetary policy and sub-4% unemployment.

Pricing in bond markets suggests a remarkable degree of confidence in the ability of the Fed to steer the economy to safe harbour.

The long sweep of history tells us two things about inflation. First, the economy operates within distinct inflation regimes. These tend to be long-lasting, often encompassing numerous business cycles. Within each regime, the political and policy backdrop shapes the average level and volatility of inflation.

Shifts in the inflation regime go hand-in-hand with economic disruption. They cannot be disentangled from the political dynamics of the day. Consider the breakdown of the Gold Standard after World War I; the creation of the Bretton Woods system after World War II; the slow collapse of Bretton Woods from the mid-1960s; the fight against inflation through the 1980s; and the move to independent inflation-targeting central banks from the early 1990s. In each case, the end of the existing monetary order and the emergence of a new anchor for macroeconomic policy had its roots in political developments. Importantly, for our purposes, there was also a clear shift to a new inflation regime.

The second observation is that when resource utilisation is high and persistent, it will generate inflation and/or imbalances within the economy. The link between them is likely to be far more complex than the simple Phillips curve model implies. Nevertheless, running the economy hot will eventually cause problems to emerge.

This need not trigger a break in the underlying inflation regime. Indeed, the more common pattern is for monetary tightening, in response to rising inflation, to trigger a recession, thereby keeping the economy within the existing regime. Yet it might break the regime – and has in the past, especially when combined with malign social and political dynamics that threaten the existing policy order.

Put differently, the economy operates within a corridor of stability much of the time – but every now and then, a shock pushes the economic system to a point where destabilising, reflexive forces come to dominate. Normally, policy is able to stabilise the economy without material disruption or political upheaval. But over time the corridor can narrow. This could be because financial imbalances are building under the surface (as Hyman Minsky argued); because an inflationary bias is becoming embedded in the system (as Milton Friedman believed); or alternatively, because the political backdrop is becoming more hostile to the existing policy regime. The more malign the political dynamics, the narrower the corridor will become – and the smaller the cyclical shock required to unleash destabilising forces.

How narrow has the corridor become today? Might current Fed policy be creating the inflationary dry-tinder that will bring down the existing inflation regime, as it did 50 years ago?

Much has changed over the intervening half century, culturally, politically and economically. In the 1960s, economies operated within the Bretton Woods fixed exchange-rate system. Cross-border capital flows, especially portfolio and banking flows, were heavily restricted. Fiscal policy was used more actively to manage aggregate demand. Monetary policy was geared to minimise pressures on the exchange rate, as much as it was used to steer growth.

Meanwhile, the supply-side of the economy operated very differently. By the mid-1960s, there had been two decades of post-war reconstruction, involving rapid productivity growth and expansion of the capital stock. The underlying, sustainable pace of growth was higher than it is today. In addition, goods production was a much bigger slice of aggregate economic activity: since goods prices tend to be less sticky than those in the service sector, there was a natural tendency for overall inflation to be more volatile.

In the labour market, trade unions had much greater influence in the wage-setting process. One-third of the US workforce was unionised. Compared with today, there was a closer link between past inflation and current pay growth, and greater sensitivity of wages to the unemployment rate. In short, any trend in inflation was more likely to persist into the future.

But for all these differences, there are similarities in the macroeconomic and policy environments then and now. Most notably because of the very low rate of unemployment, emerging after a prolonged period of unusually low inflation. Only 3.7% of the US labour force was unemployed in November 2018.⁷ Available indicators suggest US jobs growth is running well ahead of its steady-state level of 80,000 to 100,000 net new jobs a month.⁸

The transcripts and minutes of the Fed’s rate-setting Federal Open Market Committee (FOMC) meetings 50 years ago are instructive. It is clear that the lack of an inflation response, as unemployment fell rapidly from 1963, strongly influenced policymakers’ attitude to the cyclical state of the economy. For the Fed, there was no apparent urgency to lean against rising inflation after 1965.

The committee’s debates towards the end of 1966 are notable. By then, core inflation had climbed to 3.5%⁹ (from 1.25% a year earlier) and unit labour costs were advancing quickly. Spending on the Vietnam War was rising sharply. And there were suspicions of more fiscal stimulus than was being officially documented at the time.

Although the 1966 jump in inflation was clearly a concern, softening demand in the private sector left the Fed comfortable that it had done enough by tightening policy earlier in the year. Indeed, by spring 1967 it was actively loosening monetary policy – a major blunder as it turned out. By year-end, the economy was once again booming, credit growth was rising sharply and inflation had reached 4%.¹⁰ The die was cast…

Much the same complacency is evident on today’s FOMC. Sluggish wage growth and on-target inflation in the context of low unemployment are seen as convincing evidence that inflation risks are low. Inflation is forecast to rise very gradually, overshooting the target by a minimal, almost absurdly small, amount. It seems to us that the FOMC is once again consumed by an unjustified degree of confidence that the US can avoid a meaningful burst of cyclical overheating.

One obvious malign development common to both periods is late-cycle fiscal expansion. Under Lyndon Johnson, the US saw a massive fiscal loosening in the late 1960s, notably in 1966 and 1967 when the stimulus from surging government spending dwarfed the headwinds from tax hikes.

The fiscal loosening taking place currently – both the Tax Cuts & Jobs Act and increased Federal spending limits – is certainly smaller in magnitude. But it is nonetheless sizeable and its stimulatory impact skewed to the upside, given the dramatic reduction in individual and corporate marginal tax rates.

We don’t want to overplay the comparison between today’s economic environment and that of the late 1960s, nor suggest that the earlier period offers a cast-iron guide to where US inflation will head over the next few years. A sustained burst of high inflation (>5%) will require a dramatic shift in macroeconomic policy and the US political backdrop. However, there are undoubted similarities and lessons to learn.

Neither financial markets nor the Fed view a sustained period of above-target inflation – say, core PCE inflation above 2.5% – as remotely likely. Yet, there remains considerable uncertainty about why central banks have found it so hard to push inflation back to target. And we know little about the behaviour of inflation when unemployment drops to a very low level. The experience of the 1960s suggests prices and wages can accelerate rapidly, without any obvious trigger, when the economy is overheating and macroeconomic policy fails to lean against the boom.¹¹

It also suggests that changes in the structure of the economy can have an outsized role in shaping the inflationary backdrop. Rapid, capex-driven productivity growth was a powerful disinflationary force after World War II. This hid from view the build-up of cyclical inflation risks through the 1960s. For much of the past 30 years, there have also been slow-moving, but nonetheless powerful, forces bearing down on inflation: the expansion of the global labour force aided by China; the economic liberation of Eastern Europe; competitive gains from globalisation and technology; headwinds from the credit crisis in 2008; the political support for a free and open global trading system; and the effect of the baby-boom generation on countries’ age structure.¹² Some of these shifts have gone into reverse (such as demography), others have merely stalled. At a minimum, the disinflationary tailwinds of the last three decades are blowing more softly.

Almost all of the current debate is about the path of inflation in this cycle, focused on the magnitude and persistence of the cyclical impulse to inflation. Yet there is a far more important question – is this impulse strong enough to undermine the existing inflation regime? It was in the 1960s. We think it might be this time around. And it’s a scenario financial markets are ill-prepared for.

The 1960s should serve as a reminder that an inflationary impulse can build slowly and undetected over a long period; and that, once unleashed, it can be very hard to contain. The Fed was forced to engineer a recession in 1970, raising rates by five percentage points between 1967 and 1969. It was the biggest macroeconomic shock since 1958 but failed utterly to rid the US economy of its inflationary bias. The high-growth, low-inflation regime gave way to something more malign. With this new regime came new dynamics in financial markets. Inflation risk was re-introduced to the world’s risk-free asset.

This will not happen overnight. In our view, the real inflationary danger is not as we head into the next downturn, but as we exit from it. It is only once we have again stared into the deflationary ditch that the dominant policy paradigm can be challenged – and overthrown. This is the moment when the rules-of-the-game will change, possibly abruptly.

It is true that economic regimes don’t die quickly: they wither. The existing economic order might fracture in this business cycle, or the next. The current cyclical upswing in US inflation may be snuffed out as the Fed tightens policy more aggressively than the markets anticipate. It’s possible, in the resulting recession, that policymakers do resist the siren calls of populism, responding in a conventional manner, and accepting the inevitably slow rebound in output and employment.

The stage will be set for a radical rethinking of macroeconomic policy.

Yet it would be unwise to bank on this. To us, it seems more likely that the existing policy regime faces a full-frontal assault in the next recession. When monetary policy fails to bring about a strong recovery, it will be seen to have failed. What the political consequences will be, and how quickly they unfold, are uncertain. But the contours of the next post-recession phase seem evident. The populist charge-sheet has already been written: the liberal elite will have, once again, bailed out friends on Wall Street, printing money to prop up their wealth; global financial markets will have been supported at the expense of hard-working families; and experts will be recommending punishing austerity, so that foreign bond-holders can be repaid…

How might this play out? First, given the lack of conventional monetary and fiscal ammunition, we believe unconventional weapons will be used to fight the next downturn, and that their unpopularity will deepen. Second, any recovery will be slow and fragile. Third, public anger will be directed towards those deploying these weapons. Fourth, populists will be emboldened, accelerating the disintegration of liberal, centre-ground parties across the West.

The stage will be set for a radical rethinking of macroeconomic policy. Can central bank independence survive in its current form? It is hard to envisage an inflationary rupture in the existing regime without the effective end of operationally-independent central banks.

Populists will surely ask: if central banks can print money to buy financial assets, why can’t they do the same to finance higher government spending and tax cuts? This opens the door to a far more radical menu of options to support the economy and jobs. So-called helicopter money – more accurately, money-financed fiscal expansion – would seem but another step on the policy journey that began in 2008.

But this step will likely be taken in uncompromising circumstances, with the reputation of the technocratic elite trashed. More a forced takeover of the central bank by the state than harmonious co-operation between the monetary and fiscal authorities.

With this comes a change in the rules of the game. Less focus on price stability, and more on maximum employment. Less concern about the perils of high inflation, and more about the long-term damage from low investment and high unemployment. Less use of interest rates to guide the economy; more active intervention in the credit system. Less tolerance of cross-border capital flows; more active use of the exchange rate to support demand. And so the list continues.

In short, we would be in a new, more inflationary, policy regime. Investors must be alive to this very real possibility – and build portfolios that protect wealth should we find ourselves there.