|  | | | | What if the Fed has no control? |
| On Thursday, December 12, 1799, a healthy 67-year old Virginia farmer and former U.S. President by the name of George Washington went out for several hours on horseback to supervise activities in the field. The weather shifted over the course of the afternoon from light snow to hail and finally rain. Washington returned to his Mount Vernon home in wet clothes.
Punctuality was a priority for the Commander of the Continental Army. So as not to delay dinner, Washington took his meal without changing first. The next morning brought three more inches of snow and a sore throat. Nonetheless, Washington headed out to attend to trees on his property that needed clearing.
Over the course of that afternoon and evening, Washington’s voice became increasingly hoarse. He awoke at 2am that night in extreme discomfort. Multiple doctors were summoned.
Applying the accepted medical wisdom of the day, these doctors used leeches and other methods to bleed George Washington in an attempt to cure him. The more his condition worsened, the more blood they extracted. In total, thirty-two ounces of blood were removed. |
| | Doctor, I die hard; but I am not afraid to go; I believed from my first attack that I should not survive it; my breath can not last long. - George Washington, Friday the 13th of December, 1799 |
| | Late in the evening of Saturday, December 14, 1799, George Washington died in his bed. He was surrounded by physicians and family members.
While he was suffering from an apparent throat infection, modern day doctors generally attribute his death to blood loss. Approximately 20% of his blood was taken, crossing a threshold that is often fatal. |
|  | Washington on his deathbed |
| After Washington died, there was some debate over the role of blood-letting. There was an acknowledgement that it was ineffective in this case, but the practice would continue to be an accepted medical treatment.
In fact, blood-letting remained prominent through the mid-to-late 19th century, until the medical establishment finally recognized epidemiological data that showed it was useless.
Scientific relationships and techniques that are accepted and applied without question in one era seem barbaric to later generations. How could Washington’s doctors have gotten it so wrong?
Economics is similar to medicine in that cause and effect are not so easily determined. In hard sciences like physics or chemistry, experiments often take place in laboratories under near-perfect conditions that prevent the intrusion of other variables.
Economics and medicine, as applied sciences, almost always take place in the real world. Conclusions are therefore more vulnerable to alternative explanations.
Economics is inherently ambiguous. Nonetheless, economists, like doctors, can become quite attached to their opinions about how the world works.
If you not only believe in “Opinion A” but have consistently told other people over the course of your career that they too should believe in Opinion A, you have many reasons to maintain your commitment to Opinion A. These range from psychological to self-serving professional motivations.
The mere fact that most of your peers continue to believe in Opinion A may be reason enough to stand by it. Holding a minority viewpoint can be uncomfortable at a minimum and often personally dangerous. It is always easier to go along with dominant viewpoints. |
| | What the herd hates most is the one who thinks differently; it is not so much the opinion itself, but the audacity of wanting to think for themselves, something that they do not know how to do. - Arthur Schopenhauer |
| | In macroeconomics, the idea that inflation can be controlled through interest rate manipulation is a dominant viewpoint. The functioning of the Federal Reserve is largely built around this particular belief.
The logical framework behind this belief is simple and intuitive. When interest rates are reduced, demand for money is stimulated. Individuals and businesses borrow, spend and invest more willingly as debt is not only cheaper, but there is less of a reward to save.
Interest rates are seen as a throttle for the economy. When economic conditions are weak, the Fed should cut rates and inject some fuel into the system. But when inflation starts to develop, that means the economy is “overheating,” like an engine with a red blinking light. It’s now time to take the foot off the gas and lift rates.
The presumed relationship between interest rate changes and economic activity is so well-established that it is almost seen as a law of nature. Yet people are starting to notice problems.
An article published by Bloomberg on April 16, 2024 provocatively asks, What If Fed Rate Hikes Are Actually Sparking US Economic Boom? |
| | What if, they ask, all those interest-rate hikes the past two years are actually boosting the economy? In other words, maybe the economy isn’t booming despite higher rates but rather because of them. It’s an idea so radical that in mainstream academic and financial circles, it borders on heresy… But the new converts — along with a handful who confess to being at least curious about the idea — say the economic evidence is becoming impossible to ignore. - Ye Xie, Bloomberg, 4/16/2024 |
| | The article goes on to cite economists, investors and even JPMorgan strategists, all of whom are moving toward the conclusion that what we think we know about interest rates and the economy may not be right.
This is not the first time the relationship has been questioned. Following the Global Financial Crisis (GFC) of 2008 and 2009, there was acute concern that Fed rate cuts and successive waves of QE (Quantitative Easing) would produce, in the words of famed investor Jim Rogers, “an inflationary holocaust.”
Yet from year-end 2008 through year-end 2019, a period of time that roughly takes us from the GFC to the pandemic, monthly CPI only averaged 2.15%. With post-GFC monetary conditions so loose, observers wondered why we saw so little inflation. |
|  | | In the same way, people wonder today why inflation and overall economic activity continue to show such strength. After all, the Fed Funds rate was lifted more than 5% over the past couple years. Shouldn’t the economy have been brought to a screeching halt?
The experience with Japan has also led to a great deal of head-scratching. The Bank of Japan can reasonably be described as one of the most dovish of major central banks.
Japan’s central bank has consistently produced some of the lowest interest rates in the world. The BOJ even pioneered the use of negative interest rates, which until March of this year had been in place for approximately eight years.
Only now, with economies across the world experiencing significantly elevated inflation rates, is the Japanese economy able to sustain inflation at or above BOJ targets of 2%.
There seem to be many empirical contradictions to conventional thinking on interest rates. One of most thorough theoretical challenges to this thinking comes from economist Stephen Williams, who was a visiting scholar at the Federal Reserve Bank of St. Louis.
In a 2018 paper entitled Inflation Control: Do Central Bankers Have It Right?, Williams explored the “Neo-Fisherian” perspective, which builds on the work of legendary economist Irving Fisher.
Irving Fisher is unfortunately remembered for making one of the worst stock market forecasts of all time, when he stated nine days before the great crash of 1929 that the market had reached a “permanently high plateau.”
But his contributions to the field of economics in the pre-World War II era were extensive. Milton Friedman called Fisher “the greatest economist the United States has ever produced.” |
|  | | Neo-Fisherism flips the conventional wisdom on its head. The main idea behind Neo-Fisherism is that interest rates actually drive inflation rates—in order to stabilize real interest rates, which are determined by factors outside of monetary policy.
Higher interest rates require higher inflation rates! |
| | Neo-Fisherism in a nutshell Real interest rates are stable over time and are driven by non-monetary factors. Nominal interest rates equal real interest rates plus inflation rates. If nominal interest rates rise, inflation rates must rise (and vice versa). High interest rates cause inflation (and vice versa).
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| | Conventional thinking on interest rates and inflation focuses on the demand side of the equation. Low rates mean a greater tendency to borrow and spend, which is seen as inflationary.
But what about the supply side? Low rates also mean it is cheaper to create capacity (e.g., to build a factory). That means in a low rate environment, more capacity will be created to meet demand.
In a high interest rate environment, higher prices are required to incentivize businesses to invest in new capacity. Debt is more expensive, and businesses can earn good returns parking their money in the bank. If there are shortages in the marketplace, capacity does not get added until prices are high enough to justify the investment. |
| We are not here to argue that the Neo-Fisherian model is the correct one. Nor are we here to argue that the conventional wisdom on interest rates is completely wrong.
We are here to raise questions and outline potential scenarios. Not for the sake of it, but because we feel there are tremendous uncertainties with respect to the ongoing battle against inflation that the Fed is currently waging.
When it comes to the relationship between interest rates and inflation, we can think of several other possibilities to consider as well.
What if interest rate manipulations worked in the past but as a result of changes in the economy and the banking system, they are no longer as effective as they once were?
What if interest rate changes are effective in certain circumstances, but not others?
In a capacity-constrained environment (low unemployment and supply chain bottlenecks), are the supply-side effects more impactful than the demand-side?
A former colleague of Rob’s recently raised another potential twist to this debate.
What if the massive explosion of public debt burdens in the aftermath of the pandemic has reshaped central banking entirely?
In a recent piece in the Australian Financial Review, long-time bond manager Vimal Gor asserts the idea that central banks now have one key function: “to facilitate the rollover of debt.” |
| | Unfortunately, because of massive spending during the pandemic, the fiscal arithmetic of governments just doesn’t add up. The only way they can finance their spending promises is to monetise the debt. This increases the central bank’s balance sheet, which has the benefit of debasing the currency and forcing asset prices higher. - Vimal Gor, 4/21/2024 |
| | If Vimal is correct, we have potentially entered a new era of monetary policy that will revolve around the accommodation of unprecedented debt loads. Central bankers may now be compelled to generate a certain level of inflation, well above previous targets. They will do this to manufacture nominal growth in assets and incomes that will be necessary to generate the tax revenues needed to keep their governments solvent.
Action bias
One of the explanations provided for the persistence of leeching and blood-letting centuries ago was the need to do something. Both patients and physicians alike wanted to feel like they had some degree of control over the situation.
We are willing to believe the Board of Governors of the Federal Reserve has good intentions, just as George Washington’s doctors did. But centuries from now, it’s quite possible human beings will look back on this experience and ask themselves the same question they might ask of Washington’s doctors.
What were they thinking?
In the meantime, we believe investors should take little comfort in the apparent self-confidence of our monetary policymakers. Instead, they should be prepared for a wide range of potential scenarios regarding inflation.
Our Inflation Protection Model Portfolio represents a list of potential investments that we believe will benefit from elevated inflation rates in the future. |
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