Hiking into a recession

CPI came in hot again. Worse still,?next month’s?CPI may print with an 8-handle, too: The Cleveland Fed’s Nowcasting model sees inflation at 8.04% in October.?

Ugh.

That is bad news: In its effort to tame inflation, the Fed is likely to keep hiking us into recession.

And the really bad news is that it may not be a garden variety, two-quarters-of-negative-growth type of recession: With gilt yields back above 5% this morning and the yen falling below 145, things are starting to break.

But the Fed seems as intent as ever to fight inflation by inducing a recession.

And here’s the really,?really?bad news: It might not work.

Revisionist Monetary History

The current bout of inflation has forced policymakers, economists and (most importantly) newsletter writers to revisit the 1970s.

As the story goes, exploding energy prices, deficit spending on LBJ’s Great Society and the war in Vietnam, and two dovish Fed chairs (William Martin and Arthur Burns) ignited a vicious cycle of ever-rising prices — one that only ended with the recessions caused by Paul Volcker’s shockingly aggressive rate hikes.

The parallels to the current situation are obvious: skyrocketing energy prices, unprecedented deficit spending (in response to the pandemic), as well as a hopelessly behind-the-curve Fed have brought inflation back from the dead.?

But we may be missing the most relevant parallel to way-back-when: the Nifty Fifty.?

In the 1960s, a mania for growth stocks became a black hole for dollars: Investors wanted large-cap growth — and only large-cap growth.

The result was a decade of underinvestment in the energy sector that left US oil producers unable to respond to the crisis that started with surging oil prices in 1973.?

Sound familiar?

It should. The same pattern played out in the 1990s when energy went underinvested while investors only had eyes for dot-com stocks. And then again in the 2010s with the craze for FANG stocks.

In both the ‘70s and ‘90s, the investment pendulum eventually swung the other way: When the 1973 energy crisis popped the Nifty Fifty bubble, investment started flowing into energy, resulting in a much-needed boom in oil-field capex.

Some economists believe it was that capex boom — not Volcker’s recessions — that killed inflation in the early ‘80s.

This makes sense to me: If the two recessions of the 1970s weren’t enough to kill inflation, why should we think the two recessions of the 1980s were?

We can take this contrarian argument a step further and argue the best thing about Volcker’s rate hikes was that they came too late to hinder the supply response to the energy crisis: Higher interest rates discourage investment, and it was the investment in oil-field capex that led to the supply response that crushed inflation.

Jeff Currie, head of commodity research for Goldman Sachs, addressed this in a recent podcast, asking, “Who solved the inflation problem longer term? Was it Volcker or was it Burns?”?

He went on to make the case for Burns, who, by dragging his feet on rate hikes, facilitated “the largest capex boom we’ve ever seen in modern economic data.”

(Full disclosure: I’m a sucker for both contrarian takes and revisionist history, so it’s impossible for me to resist this contrarian, revisionist argument.)

By that logic, the real hero of the story is not Paul Volcker, but Arthur Burns: Letting inflation run hot in the 1970s incentivized the supply response that went on to tamper inflation in the 1980s.?

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We Need a Hero?

If Chair Burns was, in fact, the real hero, here, he was an unwitting one.

In a lengthy 1979 speech addressing the seemingly intractable problem of inflation, Burns gave oil prices just a single mention.

Mostly, he placed the blame for inflation on “philosophic and political currents that were transforming America,” including American workers’ increasing insistence on “enjoying coffee breaks.”

He did put an emphasis on declining productivity, citing “the discouragement of business investment.”

But he never suggested his lower interest rates were intended to incentivize that investment.

Instead, he blamed the Fed for going along with the “philosophical and political currents” he so obviously disapproved of.

As heroes go, then, he’s perhaps more of a bumbling Monty Burns accidentally producing renewable energy then he is…well, some other, more-laudable type of Burns. (Robert? Ken?)

Time to Spend

So, Arthur Burns may not be the hero we want, but is he the hero we need??

We’ve put our full faith in the Paul Volcker story of inflation fighting: Inflation is bad, and recessions are the only thing for it.

But while we wait for our Volcker-inspired recession to begin, we should be aware, for all the pain it induces, it’s likely to be a temporary fix (at best).?

If inflation is a longer-term problem, the only solution is investment.?

(And if it’s not a longer-term problem, what are we even doing???)

Thus far, those investments are not being made: We’ve had the requisite bust in growth stocks, but we have not had the subsequent rotation of investment dollars into energy capex.

We?have?had a rotation into energy?stocks. But for various reasons — public policy, ESG mandates, indexing — energy companies are not investing like they did in the 1970s and 2000s.?

And energy is not the only issue: de-globalization, reshoring, shrinking labor supply…These are big-picture, supply-side drivers of inflation that can only be offset by investment.

The Fed is breaking things and telling us to expect pain — which does nothing to encourage it.

—?Byron Gilliam

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