The term “extraordinary times” is probably overused these days, but it is fair to say that we are experiencing economic, market and geopolitical events that have not been seen in quite some time. One must look back to the early ‘80s to find headline inflation at today’s levels, to the ‘70s to find such a hawkish Fed and to the ‘40s to find a state-level, hot war on the European continent. All of that plus a waning pandemic that shook the global economy for two years and upended modern beliefs about globalized supply chains, so it is fair to say we have a novel set of variables for today’s investors.
Narrowing the discussion to US economic conditions, inflation and the Fed, the reference point for today’s debate is the ‘70s, which is the period when “stagflation” became a well-known word: high inflation paired with and/or leading to economic contraction and rising unemployment. The period from 1970 to 1982 saw two significant rises in inflation and four measured recessions, with unemployment peaking at 10.8% at the end of 1982. Headline CPI peaked at just under 15% in the second quarter of 1980 and the Volker Fed undertook an extraordinarily aggressive tightening program during that period, setting the Fed Funds rate as high as 20% to quash inflation. While the S&P traded mostly sideways during this period with a few false starts, the sustained equity rally finally began in the summer of 1982 when the economy was still in recession and the Fed had been easing for several months.
The next four decades saw dramatic changes in the US economy, inflation, geopolitics, technology and, of course, the Fed’s relationship with the markets. Through the late ‘80s and the ‘90s, the global landscape changed significantly as the Iron Curtain fell, the Euro was adopted, China’s invitation to the WTO cemented it as a global player and NAFTA materially eased trade across the coterminous US borders. The ability to globalize supply chains and seek the lowest input costs (e.g., labor) combined with technology and capital friendly tax policy ushered in an era of significant expansion without the risk of inflationary pressure.
By the late ‘90s, the engines of growth were firing on most cylinders. Technology innovation and a highly competitive global market for input pricing, as well as substantially deregulated markets, allowed capital to move faster and in larger quantities to fuel the long run expansion. The Fed’s role in the economy and markets changed as well, as the Greenspan Fed identified the interdependency between capital allocation and economic growth and raised its priority in the Fed’s decision hierarchy. The intervention in the late ‘90s ranged from symbolic (coining “irrational exuberance” to signal excessive valuation) to active interdiction (the Fed’s forced solution to the Long-Term Capital insolvency).
In the 2000s, the Fed began to actively engage in policy to mitigate the perceived negative economic impact of capital markets losses, and, between 2001 and 2003, the Greenspan Fed reduced the policy rate from 6.5% to 1.0% in response to the fallout from the bursting of the dotcom bubble. In 2002, then Fed Governor and student of the Great Depression Ben Bernanke gave a widely discussed speech on the difficulty of combatting deflation and the importance of maintaining inflation “buffer zones,” as well as other tools the Fed could employ to combat deflation even at a 0% Fed Funds rate (i.e., the concept of quantitative easing. The speech did not reveal new ideas per se, but it was seen as emblematic of the shift in the Fed’s dual mandate from emphasis on price stability to full employment. The Fed has always had a dual mandate, but until this era it was believed that full employment took a backseat to price stability. Of course, Bernanke would go on to lead the Fed beginning in 2006 and through the Great Financial Crisis (“GFC”), where much of the theory became practice.
Post GFC, the relationship between the Fed and the markets became even more tightly linked as the size and complexion of the Fed’s balance sheet of marketable securities brought it directly into market participation. The language of the Fed also became much more transparent during the Bernanke years, giving market participants much clearer guidance about intentions and behavior. This transparency practice has carried forward through the Yellen Fed and now with the Powell Fed (maybe the most plain-spoken ever). One can debate the positive and negative influences of the Fed’s sensitivities to the market leading up to and post the GFC. First called the “Greenspan put” then generalized to the “Fed put,” market participants became increasingly complacent about downside risk in the capital markets knowing the Fed’s concerns. It is hard to argue against the fact that the Powell Fed’s intervention in the early months of the COVID pandemic were instrumental in weathering the massive and unforeseen exogenous global shock and provided an instrumental shelter from financial catastrophe. It is certainly debatable though, whether the extended period and size of the combined monetary and fiscal stimulus contributed materially to an overinflation of asset prices in excess of what was needed for the pandemic.
To summarize, the past three decades have been marked by 1) globalization, 2) low and controlled inflation, 3) stable to declining real wages, 4) peace among large, developed nations, 5) pro-market central bank behavior, and 6) technology innovation. At this point it is safe to say that technology innovation is likely to continue, but for the rest of the factors, the jury is out. The “Happy Days” of globalization may waning and the pragmatic need to keep supply chains closer to home is more evident now than it has been in a while. The dramatic impact of country-specific COVID lockdowns exposed one significant weakness and the Russian aggression in Ukraine exposed another, so we may be entering an era where physical proximity and ideological alignment weigh more heavily into trading partner decisions than in the past. It turns out that inflation is not a thing of the past and that the Fed, for the moment, appears willing to sacrifice full employment and capital asset prices in pursuit of price stability. By all indications, the Fed has concluded that protracted elevated inflation is far worse for the American consumer than a 20-30% decline in the stock market, and that employment is likely to suffer more materially in an unchecked inflationary environment than it would with tighter monetary policy that cools demand-driven inflation. And the dynamics of the labor market have shifted a degree of power back to workers, raising the possibility of a new era of real wage growth.