The Paul Volcker Shock 2.0

A Game of Economic Whack-a-Mole

Do we have the wit and the wisdom to restore an environment of price stability without impairing economic stability? Should we fail, I fear the distortions and uncertainty generated by inflation will greatly extend and exaggerate the sense of malaise and caution...Should we succeed, I believe the stage will have been set for a new long period of prosperity.- Paul Volcker

For those who are new to our newsletter, here are our earlier insights on inflation👇

March 2022 Newsletter – Inflation Nation

22 August 2022- Idiots and Inflation

December 10, 2022 - Inflation is getting worse, and the Taylor rule

If you have not signed up for our newsletter, you can do so here👇

Earlier this month, Fed policymakers signaled that they expect one more quarter-of-a-percentage-point increase this year. Contrary to market expectations, they don't plan to deliver any interest rate cuts until 2024.

One critical reason for Feds to re-think its rate hike on the inflation front is the emergence of troubles in the banking system kicked off by the failure of Silicon Valley Bank and other financial institutions. During the Fed’s last policy meeting, the bank failures rattled financial markets and compelled authorities to bolster market liquidity. Banks also tapped record levels of emergency liquidity from the central bank.

Are investors continuing to underestimate the Feds? Might they be wrong? The graph below shows economists have grossly underestimated the persistence and amount of inflation for almost two years.

The age-old adage, this time it will be different, is based on the assumption that we learn from our past. But we have not. Today, the Volcker experience feels more relevant than ever. While inflation, per the Fed’s preferred core personal consumption expenditures (PCE) metric, is still at 4.60%, compared to 4.67% last month and 5.42% last year, well below its peaks in the 1970s and early ’80s, it’s nonetheless higher than it’s been in a long, long time.

Regardless, a Volcker-style rate hike is critical for our economy.

Paul Volcker 1.0

In August 1979, when Paul Volcker became chairman of the Federal Reserve Board, the annual average inflation rate in the United States was 9%. Today, inflation is around 6.04%.

in 1979, Inflation had risen by three percentage points over the prior 18 months, and there were indications that it was poised to continue to rise (as it did, rising to a peak of 11% in early 1980). The Fed had pursued a restrictive monetary policy to stabilize inflation on a number of occasions in the prior two decades, but each time, inflation moved higher shortly thereafter. Against a volatile international and domestic situation in the early 1980s, the Fed brought the inflation rate down to 4% by the end of 1983. During this period, the U.S. experienced two recessions generally attributed to disinflationary monetary policy, the 1981–1982 recession exhibiting the largest cumulative business cycle decline of employment and output in the post-World War II period.¹

Banking Crisis or No Big Deal?

Here is an insightful; analysis from our fellow investor and portfolio manager, Craig Shapiro,

3-Circle Investments

on the latest bank runs.

What about the Consumer Confidence?

According to the latest Gallup poll², Americans name the government as the nation’s top problem in Gallup’s latest poll, which encompassed the rocky start of the 118th Congress’ term. With high prices persisting, inflation remains the second most-cited problem (15%)

Then and Now

No one has a crystal ball. Investing is all about timing. Making sense of the Fed’s plans was impossibly difficult because the Fed itself wasn’t sure how to proceed.

The 2023 inflation is not as bad as the inflation of 1978-1982 — but it’s the worst inflation the US has experienced in decades. The Federal Reserve is raising interest rates aggressively, as Volcker did. It’s not trying to engineer a recession, but its actions could cause one as an unintended consequence. And if inflation continues to be a major problem, demands for an even more aggressive Volcker-style response will grow, and it is needed.

A rerun of the Volcker shock is a real possibility, especially since we have additional moving variables in 2023 than in 1978-1980. The Volcker era started as a rough time for the economy and ended as prosperous.

1. https://www.bu.edu/econ/files/2011/01/GKcr2005.pdf

2. https://news.gallup.com/poll/468983/cite-gov-top-problem-inflation-ranks-second.aspx

Video content is from our fellow researcher and PM, Craig. He is a long/short cross-asset portfolio manager whose investment process combines bottoms up industry and company fundamental analysis with a top down macro framework. His research process, portfolio construction and risk management frameworks, designed to generate consistent, absolute and relative risk-adjusted returns independent of market environment, were established while managing capital at Point 72 Asset Management, Ospraie Management, Graticule Asia Macro Advisors and Circle Lane Capital. His strategy invests across all major asset classes including equities/etfs/indices, commodities, fixed income, FX and crypto.