A paper tiger after all?

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Articles by Jamie

Jamie Dannhauser

Economist

14 December 2023

All faiths need a foundational myth; finance is no different.

The hero of our tale is Paul Volcker, the courageous inflation-slaying chair of the Federal Reserve (Fed), who undid the damage caused by Arthur Burns, his predecessor and our anti-hero. Like all myths, it contains a kernel of truth. But as history morphed into folklore, that truth got forgotten.

This month’s chart shows the real Fed Funds Rate from 1965 to 1979. That’s the Fed’s base interest rate minus the expected rate of inflation.

The chart reveals two periods where the central bank was forceful in driving real rates up: first at the end of the 1960s and then again from 1972.

When the history of the 1970s is told today, the Fed is accused of being insufficiently hawkish. But this misses the crucial point.

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Arthur Burns’ failure was not a lack of interest rate hikes when inflation was elevated – but repeatedly loosening policy too quickly – shown here by the fast and steep declines in real rates in 1970 and then again in 1974. It wasn’t until Volcker’s arrival that the Fed tightened policy with enough gusto to finally tame inflation.

Jerome Powell, the current Fed chair, wants to emulate Volcker by slaying the post-covid inflation dragon. His Fed is not for turning. And yet, however much Powell tells us that US monetary policy will remain sufficiently restrictive, he may end up being more Burns than Volcker. To paraphrase Chairman Mao, in appearance, this Fed is very powerful, but in reality it is nothing to be afraid of: it is a paper tiger.

Not by intent, but because the Fed does not act in a political vacuum. Arthur Burns did not set out to be a villain. Instead, his tenure was consumed by the political tumult around him, which intensified long after the inflationary genie had been released in the late 1960s.

Today, investors are locked in a debate about whether Powell’s Fed can achieve its much-vaunted soft landing. If markets are a voting machine, they are, for now, clearly backing team transitory – equities are rallying, ignoring the possibility of an earnings recession, whilst rates markets are pricing multiple Fed rate cuts in 2024.

Whether this can last is debatable – the loosening of financial conditions undermines the very narrative that nurtures this market move. We certainly think as much, hence the defensive bias of the Ruffer portfolio. Either the Fed has done enough damage and a recession is fast approaching, or Powell and his colleagues will have to lean against the recent rally in risk assets. As long as the political winds are in their favour, they won’t readily endanger their hard-won inflation-fighting credentials by cutting interest rates aggressively unless markets plummet. In this cycle, we are still travelling towards danger, not away from it.

But those political winds could change direction once a downturn is underway. Although Powell doesn’t want to be another Arthur Burns, it may not be up to him. The circumstances that made Volcker’s fight against inflation politically palatable were unusual: both the voting public and the capital-owning elite had come to detest the prolonged stagflation. Both acknowledged the need for painful medicine.

Today’s politics could not be more different. Whoever wins the 2024 election, the US will not accept a period of tight money through a recession. When a recession arrives, voters and Congress will demand – and the Fed will acquiesce to – significant rate cuts. Just as Burns did during the 1970s. His failure was not a lack of interest rate hikes when inflation was elevated, but a trigger-happy, and politically inevitable, response when the economy weakened.

Back then, the Fed failed to grasp that the underlying inflation regime was changing. The same is true today. Our portfolio is set up to protect against the cyclical downturn we believe is ahead of us; but we are also structurally positioned to shield our clients against the longer-term wealth destruction this paper-tiger Fed could inadvertently unleash.

#inflation

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