Any lingering political constraints on Volcker’s ability to do ‘whatever it takes’ to defeat inflation were, by 1979, much diminished. Both the Reagan and Thatcher administrations envisaged long-term political benefits from pursuing aggressive anti-inflation policies early in their first terms.
Although the economy has changed radically over the last five decades, we can learn from the experience of the 1970s. Jerome Powell, the current chair of the Fed, spent much of 2022 invoking Volcker’s legacy. “We will keep at it” has been a recurrent theme of his public statements, an explicit reference to Volcker’s 2018 autobiography.4 The Federal Open Market Committee (FOMC) is adamant that it will keep monetary policy tight “until the job is done.”5
In our dollar-centric financial system, whether the Fed does ‘whatever it takes’ is the most important question investors should be asking. In the near term, the answer will determine the severity and duration of the coming recession. Just as Volcker’s determination to crush inflation set the stage for the subsequent financial market regime, the actions of Powell’s Fed will do more than anything else to shape the investment environment of the next few years.
“The actions of Powell’s Fed will do more than anything else to shape the investment environment of the next few years.”
“THE DOLLAR IS OUR CURRENCY, BUT IT’S YOUR PROBLEM”
My previous contributions to the Ruffer Review have tried to illuminate the tectonic shifts shaping the economic outlook and financial market dynamics. The central message has been one of regime change, along several dimensions: macroeconomic management, domestic political legitimacy, geopolitical and geostrategic relationships, financial market structure, the energy ecosystem, digital technology’s influence and so forth.
A volatile inflationary environment is emerging, hamstrung by Sino-US geostrategic rivalry and hostile to investors. The consequences for prospective asset returns, market volatility and cross-asset correlations are numerous and profound.
This year’s piece offers a narrower, more cyclical perspective, focused on the US economy and the Fed’s efforts to bring inflation down from a 40 year high. Today, little beyond the US economic cycle matters to the FOMC. And, for investors, cyclical developments outside the US are playing second fiddle to considerations of the Fed’s reaction function and hiking cycle.
At the 1971 G10 meeting in Rome, US Secretary of the Treasury John Connally said the dollar “is our currency, but it’s your problem.” That blunt observation rings even truer today. Global asset markets increasingly dance to the same tune, orchestrated by the conductor of the dollar financial system, the Fed. Domestic economies cannot escape from the increasingly synchronised global financial cycle, even with floating exchange rates.6 And, at turning points in that cycle, almost nothing other than Fed policy seems to matter.
TRANSITORY INFLATION TO COME OUT OF RETIREMENT
Surging inflation was the story of 2022. Stable in a narrow band around 2% since the mid-1990s, it jumped to its highest level in four decades. In the average advanced economy, inflation reached 9% (Figure 1); many European countries, more exposed to imported energy and raw materials than the US, are suffering from double-digit inflation. Germany, Europe’s inflation-averse dominant economic and political power, hasn’t seen prices rise this quickly since its inflationary burst immediately after World War II. ‘Transitory inflation’, the dominant narrative when last year’s Review was being written, has been well and truly retired.
Or has it?
Source: Refinitiv, national statistical agencies, OECD, all items CPI 4 Volcker (2018), Keeping at it 5 Powell's speech at the Brookings Institution, November 2022 6 Miranda-Agrippino & Rey (2022), The global financial cycle