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Weekly Hotline


John Dessauer’s market review and update as of Wednesday December 5, 2018

             The shift in oil pricing power from OPEC to the United States is not the only economic legacy from the 1970s. In 1979 president Carter appointed Paul Volcker chairman of the Federal Reserve. In the late 1970s Americans were being battered by destructive, double-digit inflation. It was widely believed, especially among gold bugs and pessimists that the cause was the elimination of the gold standard. OPEC demanded gold for the billions of paper dollars it was receiving in exchange for oil. The United States could not allow its national gold reserves to be depleted. In response to OPEC demands, the United States severed the dollar-gold link. No longer could anyone demand gold in exchange for paper dollars. Pessimists warned that without a solid gold standard the U.S. would face high inflation. By the late 1970s that dire prediction seemed to be coming true.

            Legendary economist Milton Friedman defined inflation as “always and everywhere a monetary phenomenon.” Newly appointed Fed chair Paul Volcker attacked inflation with grim determination, tightening monetary policy even as the economy sank into a deep recession and suffering Americans pleaded for relief. Initially, Volcker said that monetary policy would operate through limits to money supply growth rather than interest rates. That lasted only a few weeks. He soon had to apply higher interest rates in his battle against inflation. He blamed Washington’s fiscal incontinence for fueling price increases.

            Milton Friedman’s definition of inflation, while widely respected, was challenged by economists who doubted monetary policy mattered much. They expected Volcker’s anti-inflation plan to fail. They thought it would take major structural reforms to weaken monopolies and labor unions to bring inflation down. Volcker’s success in beating down inflation proved the power of monetary policy. That was a defining moment. A strong, independent Federal Reserve with control of monetary policy demonstrated that it could control inflation just as well as, or better than, a gold standard. Volcker believed the “fundamental responsibility of monetary policy” is to maintain confidence in the stability of the currency.

            In 1984 we learned another lesson - it was about the limits of Federal Reserve power. Federal Reserve chair Volcker thought inflation was becoming a threat. He tightened monetary policy and raised interest rates. The U.S. dollar soared, threatening the U.S. economy. I remember traveling in London at that time. Everything looked like a bargain. The currency market effectively vetoed Volcker’s overly tight monetary policy, forcing him to reverse course and bring interest rates back down. That was a dramatic course of events. However, recently we have seen a similar, if far less dramatic, example of the currency market pushing back against the Federal Reserve. In response to recent interest rate hikes the dollar has been gaining strength. In response, last week Fed Chair Jerome Powell said interest rates are now “just below” a level that neither brakes nor boosts a healthy economy. That is a pretty clear signal that the Fed is nearing the end of its current interest rate hike plans.

            “But the more time passes, the more the 1970s look like an inflationary aberration.” (The Economist December 1, 2018) Isn’t hindsight wonderful. Yes, we have enjoyed several decades of relatively low inflation. But that is thanks to the skill and determination of Paul Volcker, who not only beat the inflation of the 1970s, but also set in place the tools to keep inflation in check. The inflation of the 1970s was not an aberration; it was the very real consequence of a global shift in oil pricing power. Thank you, Paul Volcker - not only for showing us how to prevent inflation from threating our economy and currency, but also for proving the power of monetary policy.

When the U.S. economy was threatened with a new depression in 2009, Federal Reserve chair Ben Bernanke took a page out of the Volcker lesson book and used monetary policy to counter the threat. What Bernanke did was the opposite of what Volcker did in the 1970s. Bernanke implemented Quantitative Easing or QE, a massive expansion of the money supply. Volcker used monetary policy to beat down inflation. Bernanke used monetary policy to prevent a depression. If there was a lingering doubt about the power of monetary policy, it is now gone. Of course, the pessimists predicted that Bernanke’s QE would lead to an outburst of high inflation. They were totally wrong. No, Milton Friedman is not wrong. Inflation is a monetary phenomenon. An economy on the brink of a depression responds differently to a massive increase in the money supply.

            Looking back on the inflation of the 1970s and the 2008-2009 financial crisis we have seen our strong and independent Federal Reserve successfully deal with the two greatest economic threats, inflation and depression. That inspires confidence, a counter to the never-ending, ongoing pessimistic prognostications.

            Last week the Federal Reserve published a first-ever report devoted to financial stability. The report aims to put on public display what the Federal Reserve is watching and how those parts of the market are behaving. The reports will come twice a year.

            In this first report the Fed highlighted several positive signs of resilience in the financial system, including the strong capital position of the banks, the generally tempered borrowing by households, and a system less vulnerable to the sorts of runs or credit crunches that nearly shut down the global economy in the 2007 to 2009 financial crisis.

            In terms of risks, the report pointed to stock prices that are high by some measures, commercial real estate values “growing faster than rents,” and the willingness of lenders to fund risky corporate loans. The report also touched on outside risks, from a possible trader to a messy breakup between the UK and EU. Surprisingly, the report included the Federal Reserve’s interest rate hikes as a risk.

            By highlighting current strengths and weaknesses in our financial system the report makes dire predictions of coming crises less credible. When risks are widely known they are factored into asset prices, lending decisions and capital reserve calculations. In other words, by publicly acknowledging financial system risks the Federal Reserve is reducing the risk of a future crisis.

            In a more ominous note the Federal Reserve is acknowledging the power of monetary policy to help the economy and to harm it as well. Applying a too tight monetary policy with high interest rates could precipitate an unwanted recession. That is very good news and explains why Fed Chair Powell is softening his rhetoric about raising interest rates and tightening monetary policy.

            Holding good stocks is still our best strategy.

I will have the next market review and update for you one week from today on Wednesday, December 12, 2018.  

All the best,

John Dessauer 

© December 2018