The first step is for the Fed to pause and recognize that inflation was, in fact, transitory, and the real risks are secular stagnation and deflation.T.J. KIRKPATRICK/The New York Times News Service
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The great American philosopher Yogi Berra once said, “When you come to a fork in the road, take it.” Central banks in Western economies, particularly the U.S. Federal Reserve Board, have once again arrived at such a junction.
In the next few months, they’ll have to decide whether to continue being hawkish on interest rates and risk that the recent banking crisis spreads to a full-blown financial crisis or pause their rate hikes on the path to making cuts in the latter half of the year.
This current predicament shouldn’t come as a surprise. In the spring of 2022, the Fed and other central banks faced another fork in the road as inflation ran rampant. They opted to raise interest rates based on the belief that a tight labour market caused inflation. Many, including this author, disagreed with that premise and ensuing policy move as it was supply shocks that caused the current inflationary episode.
The misdiagnosis of the source of inflation combined with the most aggressive interest rate hikes in history – in a highly levered economy, no less, with a disregard for financial stability concerns – increased the probability of yet another financial crisis. The result was the regional banking crisis that took place in March, which will have the effect of a deflationary credit shock, slowing credit creation and economic growth. Thus, accelerating central banks’ recent efforts.
So, what does that all mean for the future? It says here it will look more like the post-Second World War era, in which central banks will leave the economy to its own devices, than the post-Volcker era. The latter period that started in 1987, with former Fed chair Alan Greenspan managing the business cycle actively, is done. Central banks will now take a back seat. The great moderation is over.
With high debt levels and large central bank balances, we will enter an era of higher volatility. That means markets will take centre stage and set duration. The U.S. dollar’s place as the medium of exchange for the global economy will be questioned. Boom-bust cycles will happen more frequently. Fiscal austerity, spending cuts, or tax increases will be needed. Negative real returns on bonds, i.e., a nominal interest rate below the inflation rate, should be expected.
All that combined with extreme levels of debt means economic growth will be challenged significantly. And with foundational deflationary forces strengthened following the twin shocks of COVID-19 and Russia’s continuing invasion of Ukraine, central banks will take overnight interest rates below 2 per cent yet again.
Furthermore, the pace of evolution to a truly native digital economy will accelerate that trend. It’s a massive deflationary force many ignore. With demographics being destiny, the aging global population will catalyze slower growth and deflation. The unfunded liabilities will need to be financed as the baby boomer generation gets older, restricting fiscal policy.
To counterbalance these deflationary forces, millennials will flex their economic and political strength, leading to an evolution of social and investing norms. As in the late 1960s, with the policies of the Great Society, new social programs desired by millennials that will lead to the green economy transition should provide enough inflation to ensure interest rates stay between the 1-2 per cent range. As in the post-Second World War era, geopolitical risk will remain high. The peace dividend experienced after the fall of the Soviet Union is long gone.
What does that all mean for investment returns? According to Bloomberg LP data, the average annual return between 1945 and 1969 for the S&P 500 was 14 per cent. And there were seven bull phases during this stretch that each averaged about 24 per cent in growth.
During this period, the U.S.’s gross federal debt as a percentage of gross domestic product (GDP) declined from 120 per cent to 36 per cent while the Fed’s balance sheet declined from more than 180 per cent of GDP to less than 80 per cent. This was all achieved with nominal GDP growth rather than by paying down the debt.
Following this model, we’re entering a period in which it will take decades to grow out of the excesses of the past few decades. There’s no quick fix to our current predicament, as was the case after the Second World War.
The first step is for the Fed to pause and recognize that inflation was, in fact, transitory, and the real risks are secular stagnation and deflation. For investors, heightened volatility, low interest rates, moderate growth, low inflation, and a solid return to equities lie ahead.
James Thorne is chief market strategist at Wellington-Altus Private Wealth Inc. in Toronto.
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