Central banks are using a twentieth century tool kit to fix a twenty-first century problem

Thanksgiving done, Black Friday done, and we’re into Cyber Monday. All the signs are there that we’re into the 2024 endgame and one look at the social diary for the next week or so confirms the fact. That said, year-end is ultimately nothing other than an accounting exercise and life goes on with the problems which will be facing the world on 1 January being the very same which will have troubled it on 31 December, so best we try not to get too gooey over the deeper meaning to markets of the festive season. What we can draw, however, are a few conclusions about the state of society as a whole. Cost of living crisis be what it will, the focus will be on how resilient consumer activity will have been on Friday and today, reputedly the two most important days in both bricks and mortar and in online retailers’ year.

Markets are strange places where, as I have been saying since Adam was a boy, the focus will always be on the economic releases which support the direction in which they are wanting to go. At the moment the trending wish is quite clearly for equities to go higher and for rates to go lower. So, what do we need in order for that wish to come true? Best of course is a soft landing and a Federal Reserve, along with its friends and relations, champing at the bit to lower rates – and current price action in US markets quite clearly reflects that. Underlying that debate as ever sits the discussion over inflation, its nature, where it comes from, and what can and should be done to counter it and its corrosive effect on the economy. I was recently shown a draft paper by a reader, referred to in the past as the Apocalypticist, in which he questions the efficacy of tight monetary policy, especially in the form of high interest rates, in combatting inflation. I cannot but agree with him although in detail we approach the problem from different angles.

My correspondent refers back to the late Professor Paul Volker who as Fed Chairman from 1979 to 1987 will go down in economic history as the guy who squeezed inflation until its pips squeaked. For the benefit of younger readers who are having sleepless nights over whether the Fed will tighten or ease by a quarter  point, I might recall that rate decisions by the FOMC in 1980 took funds successively from 14% at the beginning of the year to 15% in February, then up to 20% in March, back down to 11.5% in May, 8.5% in June, back up to 10% in August, 11% in September, 12% in October, 18% in November, 20% in December and a final out of sequence cut to 18% on 29 December.  And you think we have problems now?

In fact, we do. But they are very different from the problems we had then. Although the oil shock of 1973 is widely held responsible for the surge in inflation, it was in reality nothing more than the icing on the cake. The real source of the mid-70s surge in inflation had been the Vietnam War and to a much greater extent NASA’s moon programme. If you go back to Economics 101, you will find the cause of inflation being described as too much money chasing too few goods. At its peak, the moon programme is estimated to have represented up to as much as 10% of America’s GDP. So, it’s generating lots of household income, but it is not delivering any goods to consumers. The same, of course, went for all the military hardware which was being produced at home but was immediately then sent to Vietnam. The imbalance of demand and supply primarily originated from those two sources and the exponential leap in the price of oil which followed the 1973 Yom Kippur War simply supercharged an already highly inflationary socio-economic edifice.

Add to this that it was not until 1977 that President Jimmy Carter signed into law the CRA, the Community Reinvestment Act. The CRA was intended to encourage banks to make credit available to low and moderate income neighbourhoods. In fact, it marked what was effectively the democratisation of credit. Credit, in this case that also means the availability of borrowed money to purchase whatever the consumer wishes rather than simply hire-purchase finance for TVs and sofas, had not been forthcoming to poorer citizens. Being granted a credit card had been a sign that one had arrived, that one had progressed from the working class to the middle class. No more. Even if household income might not have been rising, purchasing power was and ‘ere long many of the productive resources which had in the 60s been directed at the two great spenders, the military and NASA, turned to satisfying rapidly growing consumer demand. Was Volker knocking at an open door? Was he squeezing money supply into an economy which was already in the process of rebalancing itself? Would inflation not have fallen without the Fed and was Volker not at risk of over-egging the demand and supply pudding?

The current economic and monetary environments are very different and not least of all because since the late 1970s both public sector and household debt have mushroomed. In the mid-1970s US household debt/GDP was in the low 40% range. By the time that the GFC began to bite in 2007 that ratio had risen to over 100%. The figure has dropped back sharply to now lie in the mid-80s. I shall never forget a conversation I had with my niece some 20 years ago when she was struggling with her credit card. She had fallen victim to the trend of estimating how much one could spend based on how much one could afford to pay in interest. She was in her mid-20s and back to the wall. We agreed that the calculation should not be how much interest one could afford but how much principal one would be able to repay. Now in her mid-40s, she very consciously carries no credit card. I digress.

With indebtedness at its current elevated levels, tighter monetary policy risks becoming counterproductive. It is no longer a demand/supply imbalance that needs to be addressed. The supply chain is not a domestic affair as it largely would have been in the 1970s. Global price pressures are not in the gift of the Fed or the People’s Bank of China or any other central bank so that aggressive monetary policy becomes tantamount to turning up to a gunfight wielding a knife. 

It must be a good decade since I first argued that the monetary authorities are armed with a twentieth century monetary policy tool kit with which they are trying to fix a twenty-first century problem. As we found out to our detriment, the Midwest can produce as much grain as it can yet the global price was determined by Ukraine’s supplies which to a large part were being shipped to Africa. When in early 2022 the war was mobile and global food price inflation was taking off like one of NASA’s rockets, tightening monetary policy in Washington or Frankfurt would have been of little to no use. Raising them now, as the Bank of England is finding to its detriment, is pushing workers and enterprises alike to demand higher incomes and higher prices as the cost of their debt is driving them closer to the wall. It was of course always thus, although the sensitivity to an increased cost of money is not about annoyance but about sheer survival.

With its revenue stream directly linked to inflation, be that by way of both consumption and income taxation, governments sit pretty in an inflationary environment, added to which Mr Inflation is busily repaying the national debt pile. Non-government players in the economy, both businesses and households do not have that luxury. Yes, their debt will also decrease in real terms in line with asset price inflation – in the late 1970s one could still buy a five bedroom house in Fulham for £ 50,000 – but they rarely have the privilege of being able to capitalise interest ad infinitum which is what the public sector can and does do. The higher debt levels are, the more direct the impact of tighter monetary policy will be although within the global supply chain – it might be less open than it was a few short years ago but it is still dominant – the effect on prices will remain minimal at best.

The question must therefore be whether increasing the cost of money will help to fight inflation and eventually benefit the economy or whether in the short to medium term it will do more harm than good? The way I understood my correspondent, he believes the latter. I think I agree with him that inflation will fall with or without central banks having tightened the screws, but I also believe in Schumpeter and in creative destruction in that higher rates will, to borrow from Warren Buffett, reveal who has been swimming without shorts. A cathartic cleansing of the economy of businesses which have been living on cheap liabilities rather than productive assets is a cyclical necessity which the recently ended long period of overly cheap money has postponed for far too long.

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