The Federal Reserve: Is the Era of Printing Money Coming to an End?
There are many observations to be made today. (1) An overheating economy. (2) The worst tensions with Russia in a generation. (3) Domestic political strife. (4) Revolutionary changes to the nation’s currency. (5) Rising deficits. (6) Supply chain bottlenecks. (7) The Federal Reserve is raising rates after an aborted attempt only a few years earlier.
Like many investors, we aim to be prepared for turbulent times ahead. But will the cycle of rate hikes be, to borrow a phrase, “transitory” - the Federal Reserve quickly vanquishing inflation and returning to looser policy at the first sign of economic distress? Or has the era of printing money come to an end?
While the investment world seems full of daily volatility, one constant over the past three decades is the downward trend in interest rates. For years, central bankers around the world have been persuaded to keep the monetary floodgates open to support further economic growth, while subsequently driving real interest rates to historic lows.
Many of today’s investors may be too young to remember the double-digit inflation of the 1970s. The environment in which investment professionals blossomed was defined by the growth of available capital that powered markets for the last forty years. Rates and asset prices, by nature, have an inverse relationship. The persistent downward trend of interest rates resulted in a steady upward trend in prices, fostering unprecedented asset appreciation and wealth across the globe.
Consider the last few decades of interest rate movements: though nonlinear, the fed funds rate over this three-decade period has experienced a material decline, dropping from a near 20% high in the ‘80s, to near zero today. Over this same time horizon, the average P/E multiple of the S&P has reportedly grown nearly 2.3x.
Recently, the chaotic global macro environment, coupled with spikes in both producer and consumer prices suggests this era of frictionless capital might be coming to an end. We are now entering a period of known unknowns. To educate oneself on what may come, it helps to look to analogous periods in history. Are we facing the deep recessions and market volatility of the ‘80s, or does the U.S. economy look more like the Post-War ’40s? Or are we facing something else entirely?
Many economists, investors, politicians, and pundits have, as of late, pointed to the inflation of the ‘70s to sound the alarm of the coming economic weakness, much like that experienced in the ‘80s. It is not hard to understand why either time period seems right. During the inflationary periods of the 1940s and 1970s, we find many political, social, and economic parallels to both eras:
Geopolitically: after a period of somewhat warmer relations with Russia, we awoke to surprise Russian aggression - first with the successful test of Russian nuclear weapons in the 40s, and then the proxy wars in Korea. Tensions rose with Russian after their invasion of Afghanistan soon after America withdrew from a twenty-year war in Indochina; today, we find ourselves on the brink of yet another tense situation with Russia.
Socially: the nation is rocked by Civil rights protests and major societal shifts following the contentious presidential elections of Nixon, Carter, and then Reagan; now further segregation of left vs. right.
Economically: a long period of monetary growth in the wake of a fundamental reshaping of the Dollar following Nixon closed the gold window; the oil crisis contributed to bottlenecks in the supply chain, helping to push inflation to levels not seen in a generation; and the Fed began rate hikes in 1977, after previously aborting a period of tightening only three years earlier. Today, we begin another fed tightening cycle after years of loose monetary policy and another aborted attempt to hike rates three years earlier, in 2019.
The critical parallel we would like to point to here is the economic environment. More specifically, the economic climate and the driving forces of the ‘40s, ‘70s, and today.
In the ‘40s, inflation was driven more heavily by manufacturing disruptions as the economy transitioned from a war economy to a consumer goods driven one. As veterans came home from a victory in Europe and the nation returned to a sense of normalcy, demand for consumer goods rebounded, exacerbated by the baby boom and migration to suburban life. At the same time, high savings rates began to return to normal, and the Fed kept the monetary spigots open. The Fed’s balance sheet exploded, growing 300% during World War II. While inflation peaked at a high of 20% at the apex of the inflationary period of 1946-1948, like the early days of our current inflation, the Fed viewed this as a transitory period, driven in large part as a consequence of the Fed focusing on addressing the supply, as opposed to the price, of available credit
The ‘70s, meanwhile, were a precarious time. Following Nixon’s transition in 1971 from the gold standard to pure fiat currency, the American economy saw an explosion of credit, with the Federal Reserve enabling and encouraging extensive lending growth. While not the specific goal of the Fed, huge deficits driven by war spending and the introduction of major welfare benefits (like Medicare and Medicaid) were essentially financed by the Federal Reserve, maintaining lower interest rates than were economically sound. Once OPEC hit the market with its oil embargo, the resulting supply chain bottlenecks and sharp rise in energy prices unleashed the inflationary beast. Even after the embargo ended in ‘74, and despite the persistent cost-push frictions that remained, the Federal Reserve nevertheless started to cut rates in 1974, repeating its mistake twice in 1980 and 1981 even as inflation remained stubbornly high.
Today, we have seen years of intense protests across the political spectrum and a series of contentious election cycles. We have experienced unprecedented monetary growth while the economy’s relationship with the Dollar is being reshaped by the emergence of crypto. And following the pandemic-driven supply chain bottlenecks, we are approaching double-digit inflation, with the Fed responding with a rise in rates this month, after abandoning its last tightening cycle in 2019.
The 1940s saw comparatively mild economic pain as a consequence of ending inflation. The recession that ensued in 1948 lasted for three quarters, with employment recovering equally quickly. Markets, however, suffered for quite some time. It took the S&P almost exactly nine years to recover to its 1946 peak, right before the Fed began tightening.
“At some point this dam is going to break and the psychology is going to change,”
– Federal Reserve Chairman Paul Volker
In the ‘70s, Inflation above 2% lasted for nearly two decades, and was only finally vanquished in the mid-80s, after the Fed eventually committed to maintaining the high-interest rates needed to quash persistently rising prices while simultaneously driving us into a severe recession. At the time, Federal Reserve Chairman Paul Volker implemented a hawkish stance and doubled the fed funds rate to break the perpetuating cycle of price and asset inflation. Volker succeeded in this endeavor, and inflation was brought back under control, retreating to just over 3% in 1983. But what happened to the value of the underlying assets? The effects ultimately reverberated throughout the asset ecosystem. Real estate prices across commercial, residential, and agricultural plummeted, with the value of farmland, in particular, crashing by almost 60% in some parts of the Midwest. In comparison, the price of oil collapsed almost 58% in a matter of months. The S&P500 did not recover to its 1972 peak until nearly 15 years later, in 1987, as a result. Meanwhile, economic growth suffered a double-dip recession – while GDP growth turned negative for only six months in 1980, the economy again contracted beginning in 1981, in a recession that lasted 16 months.
So which period is more akin to what the U.S. economy is facing? While it is impossible to predict the future, we can look to the actions of the U.S. Government and the Federal Reserve that may give us some insight into what may lie in store for the American and global economies, as well as investors’ portfolios. Where it stands today, the Fed Reserve seems to be behind the curve, and there are a few observations worth highlighting.
- The chances of a soft landing seem slim – Relative to prior periods, inflation is higher, the labor market is tighter, and real rates are more negative. Whereas in prior periods the fed could raise rates without causing a recession, this time around it might be too little too late.
The Fed Balance Sheet - Naturally, given economic growth, Balance sheet expansion is to be expected. However, in terms of magnitude, the balance sheet swelled nearly $9 trillion in response to the pandemic, growing ~100%.
Total assets of the Federal Reserve
The Fed's balance sheet swelled during the pandemic to a record of nearly $9 trillion
- The impact of increasing interest rates given the size of national debt – as the largest borrower in the world, the US government will face the biggest impact of higher interest rates, which finances its Treasury bills, notes, and bonds. The public currently holds 80% of this debt.
- The magnitude of national debt – Where it stands, the US national debt is nearly $30 trillion. For FY ‘21, the US government budgeted over $562 billion in servicing federal debt obligations. This amount is larger than almost every federal department’s annual budget.
Once in a generation economic events, like the Great Depression and Great Inflation often prompt financial experts to reconsider their approach, and today is no different. A couple of years ago, we presciently wrote about the need for advisors to take a different approach to the stewardship of their clients’ capital. In our blog post, The traditional 60/40 portfolio is largely a relic of the past, we talk about the obsolescence of the portfolio construction that was designed with the intention of capturing capital appreciation through equities and subsequently mitigating risk through asset diversification into fixed income.
Flash forward less than two years and it seems that the message of this piece has only been amplified in this current environment. The problem here is two-fold: on the equity side of the equation, we have a geopolitical conflict that is slowing economic growth, which in turn points to slower earnings growth, coupled with lower valuations as a consequence of higher interest rates. On the bond side of the equation, bondholders are hit with a one-two punch from lower bond prices as a result of higher rates, while the pace of inflation means that real returns for bondholders will be lower and, in many cases, negative. In this case, the traditional 60/40 portfolio is ill-equipped to perform as well as it has relative to years past.
Moreover, much like in the ‘70s, an observation worth noting is the gradual change of money represented over these prior periods. We first observed the decoupling of the USD from gold to fiat in the ‘70s under Richard Nixon. We know that the gold standard failed as our government needed flexibility and tolls to regulate our archaic economy. Fiat currency then dawned into existence and has been utilized ever since. However, when the government in charge of monitoring our economic system prints new money, and the central bank spends an ungodly amount of money to inject liquidity into our economy through Quantitative Easing (QE), it creates an entirely new issue: an inflation tax. And this inflation tax leads to further disparities in income and wealth. Ultimately, the expanded use of cryptocurrency is what happens when the network of users no longer believes in the very agency that is meant to support the financial ecosystem. Some commentators believe that crypto may offer a novel inflationary hedge, with additional upside as its use permeates through the economy. While the volatility of many cryptocurrencies may not jive with the investment objectives of some portfolios, private markets may offer an opportunity to take advantage of the corresponding growth and importance of the infrastructure surrounding coins.
For Advisors who have never lived through a period of inflation and rising rates, maintaining the level of returns clients have come to expect may require retooling of investment offerings and value accretive strategies for clientele. If the past couple of years have taught us anything, it’s that differentiation and specialized expertise have never been more critical. In an inflationary environment that the U.S. has not seen in more than a generation, it is time to consider tossing the old 60/40 model and incorporating aspects of the new economy as they aim to achieve their objectives.
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Reuters, March 2022. " Food prices hit record high"
Barrons, March 2022. "Why Today’s Inflation Might Resemble the 1940s More Than the 1970s"
WSJ, March 2022. "The Odds Don’t Favor the Fed’s Soft Landing"
Marketwatch, March 2022. "What happens to money when the Fed starts shrinking its balance sheet?"
The Hill, January 2022. "Can our nation afford higher interest rates with the current national debt?"
Crypto.com, January 2022. "The History of Money Part 2: From Fiat to Cryptocurrency"