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Podcasts from Confluence Investment Management LLC, featuring the periodic Confluence of Ideas series, as well as two bi-weekly series: the Asset Allocation Bi-Weekly and the Bi-Weekly Geopolitical Report (new episodes posted on alternating Mondays).
Welcome to the Confluence Investment Management biweekly asset allocation report for May 27, 2024. I'm Phil Adler. Inflation in the United States may be cooling somewhat, but we're still not close to achieving the federal reserve's inflation target of 2%. Confluence advisory director Bill O'Grady joins us today to discuss whether the 2% target might change and how markets might react to that. First of all, Bill, I'm fascinated by how the Fed arrived at this 2% target in the 1st place.
Phil Adler:How did it happen?
Bill O'Grady:Well, Phil, it was complete happenstance. In 1988, the finance minister of New Zealand, Roger Douglas, was asked if the prevailing inflation rate, which had just dipped below 10%, was acceptable. We note that in the previous decade, New Zealand's inflation averaged 15% per year. Well, Douglas suggested that the only acceptable inflation rate was a range between 0 1%. That target seemed unachievable.
Bill O'Grady:But a few months later, the new governor of the Reserve Bank of New Zealand, Don Bradsh, was asked if he agreed with the finance minister's target. He suggested that he did in general, but accounting for measurement errors, a target closer to 2% was probably more reasonable. Well, the idea stuck. And because inflation was so unpopular, voters held the government to that standard, and that's how it was born. After observing the success of New Zealand on inflation, other central banks started adopting the 2% target too.
Bill O'Grady:Over time, this target has almost been universally adopted among developed nation central banks. So, clearly, this target wasn't based on rigorous analysis. If anything, it was probably, at least at first, aspirational. We note that New Zealand from 1990 to the present is average CPI of about 2.3%. So the target was taken literally.
Phil Adler:Bill, how important to the economy and to the markets is adherence to this 2% goal?
Bill O'Grady:Well, you know, on its own, it's probably not all that important. As we noted, the target was mostly just thrown out there by policymakers. But once we take into account the need to establish monetary credibility in a fiat non gold standard world, the 2% target has likely become sacred.
Phil Adler:Is there any current sentiment among policymakers that that this 2% target might be too low?
Bill O'Grady:Well, there is. 2 rather renowned economists, Olivier Blanchard and Adam Posen, have argued that the inflation level is too constricting. The fact that the Fed had a policy rate at 0 for nearly 7 years in the last decade and the European Central Bank actually had a negative policy rate is a compelling argument for raising the target.
Phil Adler:Bill, what major trends in the economy right now stand in the way of achieving this 2% goal?
Bill O'Grady:Well, the issue is less about achieving the goal. If central banks are solely focused on hitting that level, they will simply raise interest rates until the economy craters and inflation falls. In fact, some central banks only have an inflation target and arguably should do just that. But the Fed and many other central banks have a dual mandate of full employment, and raising interest rates aggressively would violate that second objective. Currently, the US, due to strong fiscal spending and tight labor market, has been unable to hit that 2% target.
Bill O'Grady:Europe, on the other hand, with much less fiscal spending, is much closer to achieving the goal. Longer term, though, deglobalization is a significant impediment to low and stable inflation. As the world breaks into blocks, as Patrick Ferrer Hernandez reports have detailed, we expect inflation to become a structural issue.
Phil Adler:Let's focus on the deficit for a moment. We're we're currently experiencing a low unemployment rate. At the same time, the federal deficit is increasing rapidly. This makes me wonder how much the deficit might balloon if unemployment rises. Bottom line, this seems ominous.
Phil Adler:Is it?
Bill O'Grady:It's a concern. Perhaps even more worrisome is that if we are heading towards some kind of conflict with China, Iran, or Russia, and it's a cold war of long duration, fiscal spending in the form of defense spending will need to rise even faster. It could be offset with taxes, but neither party seems serious about raising revenue, and with good reason. Calling for higher taxes is an election loser.
Phil Adler:Bill, your report this week suggests that central bank independence, as well as a clear inflation target, are both needed in the financial system we're living under to contain inflation and maintain confidence in the dollar. Could the rising deficit threaten central bank independence?
Bill O'Grady:Yes. The issue at its heart is how do you give money credibility? For most of the past 300 years, money was backed by gold, which acted as a constraint on government spending and, for that matter, private spending too. It was not unusual during wartime for this link between gold and money to be broken, but governments usually tried to return to the standard once hostilities ended. What we have noticed in the 19 twenties was the ability of governments to return to the gold standard was difficult.
Bill O'Grady:The gold standard required austerity to function, and in virtually all cases, it was the working classes who bore the brunt of the austerity in the form of falling wages and rising unemployment. After World War 1, as suffrage expanded to unpropertied voters, the working classes would no longer accept austerity. And so after the Great Depression, the gold standard as it was practiced before World War 1 was a dead letter. After World War 2, Britton Woods was implemented. It was a semi gold standard.
Bill O'Grady:The world's currencies were pegged to the dollar, and the dollar was pegged to gold. But that system proved on stable, leading president Nixon to end gold convertibility. And
Phil Adler:the reaction to that was dramatic?
Bill O'Grady:Well, in the report, we label the period from 1971 to 1980 as the lost years. That was the period of not just high inflation, but the economy faced issues with stagflation, which is high inflation with weak economic growth. What Paul Volcker's aggressive rate increases did was restore confidence to the dollar. But what emerged was a dollar treasury standard with the US government representing the reserve asset for the world replacing gold. And so for the first time in history, we had an international fiat as opposed to gold standard.
Bill O'Grady:To give economic actors confidence in fiat currencies, we saw saw the evolution of central bank independence and a hard inflation target to ensure to currency holders that governments would engage in austerity, protect the purchasing power of money. So this is where the deficits matter. There is a condition called fiscal dominance that emerges when government debt service costs become elevated. The central bank, under these conditions, is called upon to reduce interest rates to lower government debt service costs. At that point, central bank independence is lost.
Phil Adler:Has this ever happened?
Bill O'Grady:Well, during World War 2, the Fed fixed interest rates across the entire yield curve and purchased treasury debt to prevent rates from rising. That is fiscal dominance in its most pure form. We are in danger of seeing something similar.
Phil Adler:Bill, statements by Federal Reserve officials do pay homage to a 2% target, but I'm getting the feeling that these statements are not heartfelt. Do you think the Federal Reserve may be using rhetoric to prepare the way for public acceptance of a new higher inflation target?
Bill O'Grady:Well, there's a corollary in the currency markets. Bob Rubin was president Clinton's treasury secretary. As such, he had the mandate to manage the dollar's exchange rate. During the eighties into the early nineties, governments often intervened in the exchange rate markets and jawboned their currencies in various directions to achieve policy goals. Unfortunately, this practice was leading to excessive market volatility.
Bill O'Grady:So Rubin declared a truce. He said that the dollar would be a strong currency and would say nothing else. And during the 19 nineties, in fact, it was a strong currency. But over the next decade, the dollar fell into a bear market, and still, treasury secretaries continued the strong dollar mantra even though it had no policy content. I think this is where we're heading on the inflation target.
Bill O'Grady:I don't think it will ever change, but it won't be rescinded. It just won't be achieved, and aggressive actions to hit the target won't be taken. In other words, it won't be a true policy goal. But officially changing the target could have serious unintended consequences. Mainly, it could undermine confidence in the currency.
Phil Adler:So you're worried that a higher target might impact consumer spending behavior?
Bill O'Grady:Yes. And other things too. When the users of currency lose faith in that currency, they tend to separate the store of value function of money from the medium exchange function. They still use money to buy stuff, but they save in something else. You might recall pictures of Germans using wheelbarrows full of Marx to go shopping during the famous hyperinflation of the 19 twenties.
Bill O'Grady:Well, do note, they still use those marks to buy stuff. During the 19 seventies when inflation was high, that something else was often goods. I worked in retailing in the 19 seventies, and we loaded our stores with inventory because the cost of carrying that inventory was less than the financing cost. Of course, buying stuff to adjust to inflation exacerbates price pressures. We also note in the 19 seventies, financial products were expensive.
Bill O'Grady:Broker commissions were fixed. We traded stocks in 8ths or 12 and a half cents between the bid and ask spread. Stock trades didn't settle for 5 full days. If you moved money into the stock market, you had to have a strong conviction that you were going to keep it there for a while. Let's contrast that with today.
Bill O'Grady:We trade large cap stocks in fractions of cents between the bid and ask price. Commissions have mostly been eliminated. We're approaching t plus one, meaning stock trade settle the next day. We have been watching Turkey for a while. Equity values there have outpaced inflation, and inflation's been running as high as 80%.
Bill O'Grady:Inflation this time around could lead to asset appreciation. If inflation becomes embedded, we could see outcomes different than the 19 seventies. Clearly, we see differences in inventory accumulation, and buying patterns will change, but it may not be all that bearish for some financial assets.
Phil Adler:Looking at stocks, the major stock indexes bill have hit record territory following the release of those May consumer price numbers, which showed core inflation rose 3.6% on an annual basis, the lowest level in 3 years. Nice, but still not close to 2%. Do you think current stock market momentum might be enough to push inflation concerns to the back burner?
Bill O'Grady:What I wonder about is if this rally in equities is being solely driven by earnings or if an element of it might be tied to using equities as an inflation hedge. Inflation concerns will remain, but as I noted before, reaction from investors could be quite different.
Phil Adler:Well, how do you think this might all play out for the Fed and for the economy?
Bill O'Grady:Well, perhaps the biggest surprise might be in long duration bonds. For those of us who were around in the late 19 seventies into the early 19 eighties, we remember the culmination of the great bond bear market that ran from 1940 5 to 1980. That's what most bond investors fear. Instead, we could be in a world where the Fed and the Treasury prevent these interest rates from rising, meaning that the loss to investors won't be in the nominal price, but in the realized value after inflation. This is a condition that is commonly referred to as financial repression.
Bill O'Grady:One observation I have made is that since World War 2, we have never gone into recession with a deficit of 5% or more. The congressional budget office is projecting this level of deficit into the 20 thirties. This may mean we are nearly recession proof, and so the Fed may be in the business of mostly managing the Treasury's borrowing costs.
Phil Adler:And final question for today. How might the current tensions over a rising deficit and inflation cause you to re examine asset allocation strategies? Well,
Bill O'Grady:we've been worried about this for a while, and so that's why you see our fixed income bias towards short and intermediate term maturities, why we have gold in all of our asset allocation portfolios, and why we have favored value equities. If confidence in the dollar erodes, we could see international investing expanded, and we are prepared for military deterrence in our portfolios. But the key issue is to avoid narrative capture. That occurs when you think you have the macro situation figured out, and thus, the investing situation too, and then something unexpected happens. History never repeats exactly, and so being open to surprises makes sense.
Phil Adler:Thank you, Bill. Our discussion today is based upon sources and data believed to be accurate and reliable. Opinions and forward looking statements expressed are subject to change without notice. This information does not constitute a solicitation or an offer to buy or sell any security. Our audio engineer is Dane Stoll.
Phil Adler:I'm Phil Adler.