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Central bankers fighting inflation need good political fortune as well as skill

The writer is editor-in-chief of Money Week

It’s hard not to feel sorry for Arthur Burns, chairman of the US Federal Reserve, when you look back on the unpleasant inflation years of the 1970s. He clearly felt his failure deeply (and it was a failure—inflation averaged 6.5 percent a year during his tenure) if the title of a lecture he gave in Belgrade in 1979 is any proof. He called it “The Anguish of Central Banking”. It is useful reading today for any investor wondering where to put their money in an era when inflation is on the rise again.

The problem, Burns said, was that the Fed had “in abstracto” the power to “constrain the money supply and create enough tensions in the financial and industrial markets to end inflation with little delay.”

That this was not the case was a function of two things. First, politics. The Fed was “caught up in the philosophical and political currents that changed American life and culture” — especially the idea that “provision for bad times” was no longer a private but a public responsibility. Add the ensuing propensity for deficit spending to the increase in regulation across the economy and the high taxes that discouraged business investment and the result was inevitable: an automatic “inflationary turn”.

Second, monetary policy is very difficult. Contrary to the belief of most central bankers, there is no definitive model that works: “monetary theory . . . does not provide central bankers with decision rules that are at once firm and reliable,” as Burns put it. We may know that “excessive money creation” will cause inflation, but this knowledge “stops with mathematical precision”. The result? Surprises and mistakes in “every stage of the monetary policy process”.

In the audience in Belgrade sat Paul Volcker, the new Fed chairman, and the man now known for doing exactly what Burns thought he could only do in abstracto: fight inflation. By mid-1981, the hard man of monetary policy had interest rates approaching 20 percent and rising inflation. By the time he left in 1987, it was around 3.5 percent.

A few years later, Volcker delivered a lecture entitled “The Triumph of Central Banking?” No wonder today’s central bankers all want history to remember them as a Volcker and not a Burns. But notice the question mark in its title. A recent article by analysts at Ned Davis Research points out that Volcker had the kind of backing from domestic and global politics Burns could hardly have dreamed of. Volcker had Ronald Reagan’s supply-side revolution.

Reagan cut the regulations and broke the air traffic controllers’ union in 1981, firing 11,359 air traffic controllers at once. Volcker saw this as a turning point in the fight against the wage-price spiral. There was also a sharp rise in investment in the low-tax US investment, in addition to a very favorable productivity gain. Add to that the eventual oil price crash of 1986, the dawn of globalization and the dawn of the computer age, and you get the picture: Volcker was lucky.

This history matters. Look at the environment current Fed Chairman Jay Powell operates in and you may wonder how he could be a Volcker without Volcker’s luck. There seems little chance of productivity gains with low taxes and low regulation under President Joe Biden. There is no room for a new burst of globalization and with the labor market still very tight in the US, the risk of a (not unjustified) wage price spiral remains very high.

If you’re using the 1980s as a reference point for the speed at which savvy central bankers can fight inflation, you might want to keep the lessons of Volcker and Burns in mind. Central bank success is more a matter of luck than skill.

Outside of the US, you may also want to keep a close eye on British Prime Minister Liz Truss. There’s something of the Reaganomics in the tax cuts, the ripping of regulations, the productivity-boosting rhetoric her administration is offering — as Friday’s mini-budget unveiled by Chancellor Kwasi Kwarteng showed. The Bank of England is about to get lucky.

None of this in particular helps us know where inflation will end: since most predictions have been wrong so far, I’m afraid we have to ignore most predictions. But the fact that we can’t know helps us a little bit with our investments – in that it should remind us to build in insurance. That is almost impossible in the US. The S&P 500 is trading at a forward price-to-earnings ratio of about 17 times — a little above its historical average at a time when most other things are worse than average.

You could argue that it is a fair value if you assume that the interest rate will not exceed 5 percent and think in terms of earnings yields. But nothing else really works: GMO’s current 7-year forecast suggests an annual real return for U.S. stocks of minus 1 percent. Pain indeed.

However, there is a market where things are looking a lot better. The UK, with the help of Trussonnomics, has a forward P/E of 9 times. Profits will of course be cut, notes JPMorgan, which now sees the UK as their top choice for developed markets. But this still represents a significant “appreciation cushion.” Investors should use it.

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