Oldtimers remember Paul Volcker’s brutal treatment of runaway inflation in the 1970s and early 1980s. His decision to raise interest rates sharply caused a sharp but short recession. He did the trick. Inflation slowed and the bond market started a 40 year bull market.
The years following Volcker’s tenure were characterized by increasingly interventionist monetary policy. When the stock market crashed in October 1987, Alan Greenspan’s Fed issued the following statement: “The Federal Reserve, in accordance with its responsibilities as the nation’s central bank, has today asserted that it is ready to serve as a source of liquidity to support the economic and financial system. Investors have understood this. Greenspan had created a put option on the exchange.
As a result, the Fed gave itself a third mandate. Going forward, the Fed would not only control inflation and keep unemployment low, but it would also protect asset values. Investors cheered.
The Greenspan Put was followed by the Bernanke Put when the Great Moderation, a 20-year period of relatively low macroeconomic volatility, turned into the Great Recession that followed the 2007/2008 financial crisis. Ben Bernanke sought to smooth things over by providing liquidity again and thus the first quantitative easing (QE1) was born.
QE 1 was quickly followed by several other QEs, all with the stated aim of creating a “wealth effect”. With massive purchases of Treasuries and mortgage-backed securities, the Fed changed its policy again. No longer limited to providing liquidity to avoid a major crisis, it began to use its power to inflate asset prices and support consumption.
In the process, interest rates were kept artificially low. All the major central banks have followed suit, even to the point of pushing the yield on certain sovereign debts below zero! Historians will surely find it difficult to explain the raison d’être of an instrument whose value loss is guaranteed. The argument that the alternative could be even worse comes across as an odd way to bolster confidence in the monetary system.
Pumping things up was the easy part. But despite the past decades, economic stimulation obviously cannot last forever. Under Bernanke’s successor, Janet Yellen, the Fed failed to normalize monetary policy. He didn’t want to bear the short-term pain of raising interest rates. Instead, with eyes fixed in the rearview mirror, a “data-driven” Federal Reserve continued with low interest rates and a hugely bloated balance sheet. It was then that a pandemic virtually paralyzed world trade.
At that time, Jerome Powell had inherited a Federal Reserve that had run out of ammunition. Or so we would have thought. After all, the Fed’s balance sheet had already ballooned to over $4 trillion. But even so, it doubled. Ultimately, the Fed’s balance sheet had exploded to $9 trillion, a tenfold increase since the 2008 financial crisis. Stock prices and house prices quickly resumed their upward trend.
Powell, still focused on the rearview mirror, initially refused to recognize the danger. Inflation was described as transitory. Until that is no longer the case.
This brief history of recent monetary policy illustrates the mistake markets make in believing – or hoping – that inflation will soon come down. It will take sustained monetary tightening to reverse forty years of activism.
We have come full circle since the days of Volcker. The fight against inflation has once again become the stated priority and we are only just beginning to control it. In any normal cycle, interest rates of 4% would be considered extremely stimulative when headline inflation is above 8%. Hopefully peak interest rates are somewhere between those two numbers. It is more likely, it is feared, that rates will have to double from here before the Fed has finished tightening.
Habits die hard. Investors have become accustomed to being bailed out by central banks. However, the new financial reality is that the Fed is finally letting the markets play their role of price discovery.
The Powell Put no longer exists. Once market participants come to terms with the idea of rates rising and the Fed no longer bailing them out, we will likely see stock prices reflect corporate fundamentals again. Last year’s blind sell-off in the stock market comes at a time when the contrast between the fundamentals of different companies is becoming more apparent.
The rising tide that lifts all boats has turned. Either we are already in a global recession or we are about to enter one. In tough times, weak businesses will suffer and the strong ones will grow stronger. The blind selling of recent times does not reflect this fundamental law of nature. Selecting the winners will yield very good returns as they are very oversold.