Memo 4: The 70s
History never repeats itself. Man always does – Voltaire
These last couple memos have built the case that higher rates are driving a valuations reset. Well, technically they argued the opposite – that low rates are predominantly what drove historic gains in Paper Wealth. I’m leaving it up to you to connect the dots on the way down: live by the printer, die by the printer.
Last memo was also about as much math as I really want to get into for now, so as a courtesy to the artists, politicians, and other numerically challenged members we count among our growing subscriber community, this one will be switching gears a bit and we’ll be playing the role of historians.
Here we’ll be focusing on the why behind the Fed’s ‘decision’ to end the free money, despite as we’ve discussed, the downside risks to both markets and the economy. This catalyst of course is inflation.
We have the highest levels of inflation on record since the 70s and a lot of people are saying “This is just like the 70s.” Now I can’t say that, because I wasn’t alive in the 70s! But for many of us, this is a first encounter with inflation in our lives, much less our careers. For a variety of reasons inflation has remained dormant in modern times – probably some combination of globalization, digitization, and yes - Amazon. But now we have the highest levels of inflation on record since the 70s.
So let’s unpack. I believe we have this inflation for all of the following reasons:
Supply chain interruptions relating to
COVID lockdowns
Tariffs, sanctions, and deglobalization
Energy / environmental policy
Labor shortages driven by historically low labor force participation rates
Demand booms relating to
COVID stimulus amounting to $5T
Pent up demand – mostly for experience-based activities
Asset appreciation / the wealth effect – in last week’s memo we pointed out that this wealth is mostly Paper Wealth
Inflation expectations / predictions, which reflexively determine actual inflation in the future
This is one of my favorites: John Cochrane from Hoover’s Fiscal Theory of Price, which extends Milton Friedman’s Monetarism by linking inflation to future unpayable debt balances
I want to do a deeper dive into supply, demand, and inflation expectations next week. But to distill all of this to its simplest form: we have too much money chasing too few goods.
The 70s
The most important takeaway we can learn from the 70s… is that we call the period THE 70s… as in the whole decade.
We don’t call the period “1970,” when inflation peaked at 6% and the economy suffered a 9-month recession
We don’t call the period “1973 to 1975,” when inflation peaked at 12% and the economy suffered through a 17-month recession
We don’t’ call the period “1979” when the decade closed at 13% inflation, before hitting 15% 4 months later and entered another 7-month recession in 1980
In fact, this economic period of high inflation, rising rates, and recurring recessions really continues through the 17-month recession from 1981-1982, when inflation hit 11%:
“The 70s” were actually a 12-year war fighting inflation comprised of 4 battles and 4 recessions
For our friends, who like me are more visually inclined:
Feb-22 YoY inflation came in at 7.9%, and In March the Fed announced their inflation expectations of 4.3% for 2022 coming down to 2.6% for 2023. They expect to accomplish this by raising interest rates to 1.9% by the end of 2022 – i.e. 240 bps tighter than inflation. In other words, 10 years faster than “the 70s,” without ever raising real rates above zero. We’ll see the Fed’s revised game plan in June, but already inflation has touched 9% and rates are pushing 3%. It is my belief that our 2-year timeline to fight inflation is the economic equivalent to the 2-week lockdowns to “flatten the curve.”
No Silver Bullet
Perhaps the biggest misconception about our war against inflation is that somewhere along the way, Paul Volker figured out the secret – raising rates. This ignores the three lost battles – including Volker’s first attempt, collectively referred to as stop-and-go monetary policy and outlined below:
In 1970 rates peaked at 9%, 300 bps wider than max inflation of 6% during the period
In 1974, rates peaked at 13%, 150 bps wider than max inflation of 12% during the period
Volker takes over in 1979…
In 1980, rates peaked at 18%, 300 bps wider than max inflation of 15% during the period
Finally in 1981, rates peaked at 19%, 800 bps wider than max inflation of 11%
Given this information, I would like us all to take a moment (or a week) to think about why 1981 was successful when ’70, ’74, and ’80 were ineffectual stop-and-go attempts. Without a formed opinion, we’re flying blind to the risk ahead of us: will this time be different? Next week’s memo will address these questions. Can we stick a soft landing? Is 2020 the start of 12 years of stop-and-go inflation? Or are we cutting right to the chase: 1981… which oh by the way, was the third-worst recession on record after the Great Depression and ’08 Crisis – unemployment reached 11%, with 20%+ unemployment in auto manufacturing and residential construction. Even still, if 1980 is the right answer – do we have the pollical willpower to make it happen, and are our political and social institutions resilient enough to weather a historic recession? These are the questions we should be asking.