How Many Horsemen Make an Apocalypse?
BY: Jim McElroy
• While there is plenty to worry about, the outlook for inflation may be the most important thing.
• We know interest rates are going up, so our focus should be on whether the Fed tightens too little or too much.
• One positive so far in the outlook for inflation is that inflationary expectations may not have become self fulfilling.
• The Fed, however, is no longer using “transitory” language.
• “Soft landings” have been very elusive outcomes for the Fed.
• Much of what has been causing inflation – an absence of supply — is out of the Fed’s control; however, this may correct without any action from the Fed.
The usual answer is four: War, Plague, Famine and Death. We already have three — the Russian invasion of the Ukraine has reintroduced war and death to the West and Covid-19 qualifies as a form of plague — and the likely disruption in wheat production from Russia and the Ukraine (about 25% of world wheat exports) suggests that famine may soon complete the quartet. These are difficult times, but they’re not apocalyptic: before we start pointing to signs and omens and calling for the end of days, we should recognize that Covid-19 is not the Black Death, that a clumsy Russian invasion of the Ukraine is not yet WWIII and that a likely scarcity of wheat and resulting higher prices for bread (global food prices hit an all-time high in February) does not indicate worldwide starvation. But although we no longer believe in equestrian omens of disaster, at least not literally, these “signs” do and will have a troublesome impact on the global economy and financial markets. Further distressing signs we should add to the mix are reports of accelerating inflation and Federal Reserve pronouncements on future interest rate hikes. All these signs increase uncertainty, partially because we are relatively unfamiliar with them: it’s been over eighty years since Russia last launched a ground war upon an independent European nation, forty years since sustained monthly inflation exceeded recent measures of CPI (a trailing twelve month or TTM average of .64% in February, 7.9 % annualized) and three years since the last time the Federal Reserve raised the Fed Funds rate. On this last item, now that the Fed has raised rates by .25% and telegraphed that it will continue raising them by .25% to .50% six more times in 2022 and four times in 2023, the uncertainty is more about miscalculations than about the direction of interest rates: we know interest rates are going up, but in combatting inflation, will the Fed tighten too much or too little, too slowly or too quickly? The last time the Fed sought to quench an inflation rate comparable to today, it took about four and a half years —1977 through June of 1981 — and ushered in a deep recession. But it did stop inflation.
There are differences between today’s high inflation and that of the late 1970s. The late ‘70s inflation was the final ratchet upward of a three-step inflationary era, an era that began in the mid ‘60s when the U.S. sought to create “A Great Society” at the same time it was waging war in Vietnam, a costly guns and butter overreach. The next two inflationary periods in this era, from 1972 to 1975 and from 1977 to 1980, were stoked by extraordinary increases in energy prices, first due to the Arab oil embargo and then due to the Iran-Iraq war. Each period peaked at higher rates of trailing twelve-month inflation (6.4%, 12.1% and 14.4%), each saw higher Fed Funds rates as the Fed struggled to contain inflation (9.8%, 14.3% and 22.0%) and each ended with a recession. The last recession of this period*, which lasted for six quarters and ended in the fourth quarter of 1982, proved to be the death-knell for high inflation for almost two generations. During this high inflation era, inflation had ratcheted upward with higher highs and, following recessions, higher lows. High inflation had become an expectation and the expectation had become self-fulfilling: when the accepted wisdom is that prices are only going to increase dramatically in the future, the urge to buy now at lower prices has the effect of increasing demand and pushing prices ever higher. For investors, this meant that the need to keep ahead of inflation placed a premium on tangible assets with limited availability — gold, jewelry, real estate, one-of-a-kind collectibles, etc. — and inflated their pricing to the detriment of intangible assets, such as stocks and bonds. Fortunately, since the early 1980s, we have not seen this kind of inflation: the mantra of “buy now before it goes up”, has been largely absent from investor and consumer consciousness.
Unlike the current inflationary period, this earlier period was one that developed over time. Today’s inflation misery popped up suddenly, like a mushroom following a summer shower. So far, there has not been enough time for the population to develop an inflationary mindset: it was only a year ago that the average rolling twelve-month rate of inflation fluctuated between .5% and 3%, levels acceptable to the Fed. Then, in early 2021, about a year after the outbreak of Covid-19, the rate of inflation moved beyond the Fed’s comfort zone. As a result of the aforementioned apocalyptic horsemen of plague and war, plus the shutdowns and sanctions they brought with them, the global supply of goods and basic materials shrank while demand remained constant or, as Covid-19 mandates abated, increased. For a while (some would say for too long a while) the Fed insisted that inflation was transitory and that soon the snarls in supply chains would disentangle, disinflation would occur and price increases would return to an acceptable rate between 0% and 2%. Now that the Fed has changed its mind and begun raising overnight rates by .25% (.50% if deemed necessary) and promises significant tapering of bond purchases (and eventually net sales), the questions for investors are “will this be enough, or will it be too much?”
The Federal Reserve does not have a good history of engineering a “soft landing”; in fact, it can be argued that it has no history of producing such an effect. Every attempt to slow inflation by lifting interest rates, by fiat and/or by restrictive monetary policy, has resulted in at least some form of recession. The more resistant inflation is to Fed actions, the more severe the resulting recession. On the positive side, the relative brevity of this run of inflation (twelve months), the absence, for now, of an inflationary mindset among consumers and the discrete and possibly temporary nature of the non-economic events that created this whole mess (Covid-19 and the Russian invasion) might portend a successful, if still moderately unpleasant, conclusion to the Fed’s tightening cycle. On the negative side, The Fed is beginning its tightening regime from a very accommodative position: two years of a Fed Funds rate of 0% to .25% and a money supply (M2) growth of $6.33 trillion, or 40.9%, the fastest two-year pace since 1958 (our Fed data on money supply only goes back to January of 1959). Extremes in Fed accommodation often encourage extremes in Fed tightening.
We have some optimism that the Fed will be able to tame inflation while still avoiding a deep and long recession: in terms of traffic mishaps, we’re looking for more of a “fender-bender” than a multiple car pile-up. The current high inflation is as much due to supply shortages caused by Covid-19 and the war in the Ukraine as it is due to the easy money environment of the last two years. Under these circumstances, higher interest rates can temper consumer demand and still have little negative impact on supply chains. Today, the most important medicines for supply chain improvement are herd immunity, peace and time, cures which are outside the Fed’s control. It’s possible that the Fed’s earlier characterization of supply chain woes as transitory was in theory correct, though wrong in timing: since about half of the inflationary gap between demand and supply could correct over time, the Fed may not need to boost interest rates as high as it has advertised.
Currently, fixed income yields are quite low — the One-Year T-Bill yields 1.61%, the Ten-Year Treasury Note yields 2.34% — and in real terms (after inflation) quite negative. At current levels and based on the Fed’s stated game plan, we estimate that the Fed will likely invert the yield curve in about twelve months. This could happen sooner if it accelerates to .50% steps and/or longer rates begin to decline in anticipation of a recession. We should note that an inverted yield curve does not necessarily imply an impending recession, though it is a very strong cue: while every recession has been preceded by a yield curve inversion, not every inversion has led to a recession. The point we wish to make is that we think the Fed has about a year to get this right, to subdue inflation and avoid a deep and crushing recession. If they don’t, then we may be adding a fifth horseman to our list of malevolent messengers.
*There were four recessions during this period, though the third one, which lasted for just over two months in early 1980, is usually ignored or considered as a preamble to the 18-month recession of 1981-82.
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This information is intended to assist investors. The information does not constitute investment advice or an offer to invest or to provide management services. It is not our intention to state, indicate, or imply in any manner that current or past results are indicative of future results or expectations. As with all investments, there are associated risks and you could lose money investing. Argent Financial Group is the parent company of Argent Trust, Heritage Trust and AmeriTrust.
