Arthur Burns, William Miller and learning the right lessons from history - Angles & Perspectives Q2 2023

Arthur Burns, William Miller and learning the right lessons from history

How policymakers deal with inflation is once again of crucial importance. Current consensus is that former US Federal Reserve Chairman Paul Volcker’s policy of maintaining high real interest rates, even in the face of a weak economy, is what reduced ‘inflation expectations’ and finally beat US inflation in the early 1980s. More importantly, this is clearly what current Fed Chairman Jerome Powell believes.

We view this as a misdiagnosis of the 1970s and 1980s economy that ignores the multi-faceted nature of an inflationary environment. Inflation is once again the key issue for the US Federal Reserve (Fed), and it’s clear that the policymaker response is based on the Volcker narrative. While suppressing demand through higher interest rates can temporarily reduce inflation, as soon as growth returns, inflationary pressures will reappear. That implies we are very likely to remain in a volatile macroeconomic environment, the antithesis of the ‘secular stagnation’ that prevailed over much of the past 15 years.

Long duration assets are once again being deeply overpriced, based on a misdiagnosis of the inflationary environment. As this becomes evident, these overpriced assets will derate, causing significant losses for headlines indices and many investors. This economic volatility will continue until the root causes of inflation are addressed.

Study history and avoid mistakes?

In the field of economics and finance, knowledge appears to be cyclical. The cycles are often long, lasting many decades, and policymakers and market participants appear to be doomed to repeat similar mistakes to those of their predecessors. Despite huge advances in the speed of communication, data availability and the computing power for analysis, underpinning it all is a market made up of a multitude of people – people with their hopes and fears, prior beliefs and ingrained biases. The people, the models say, will always make independent rational decisions, but when it really counts, they often collectively act impulsively or emotionally.

A study of history is the obvious potential remedy to this. We spend many hours reading history, both of financial markets and economics, and more generally. If only it was that easy! Unfortunately, it seems fraught with ‘resulting’. Policy errors and mistakes are always obvious with the benefit of hindsight, so we, and in many cases the authors of what we are reading, imagine we could never make them again today. To truly appreciate the choices available to policymakers and participants, as they saw them at the time, and hence genuinely understand history, is hard to do.

Learning the wrong lessons from ‘The Great Inflation’

The last time developed countries had inflation rates as high as the recent levels was 40 years ago, at the end of the so-called ‘Great Inflation’ from 1965 to 1982. A deeper understanding of the economic history of this period has suddenly become very relevant for current policymakers and market participants. 

Paul Volcker and the ‘inflation expectations’ narrative

The ruling narrative on why inflation took so long to control in the 1970s centres on the idea that policymakers allowed ‘inflationary expectations’ of consumers and businesses to become unhinged. It was only after Paul Volcker became Fed Chair in late 1979 and changed monetary policy that these inflationary expectations could be purged. This was a long and painful process involving increasing the federal funds rate to an incredible 20% (twice!), two recessions and mass unemployment. Only after this could the economy once again experience growth with only moderate inflation. It is clear that this is both the consensus narrative and, more importantly, the lesson the current Federal Reserve Board has taken from the history of ‘The Great Inflation’.

The longer the current bout of high inflation continues, the greater the chance that expectations of higher inflation will become entrenched… The successful Volcker disinflation in the early 1980s followed multiple failed attempts to lower inflation over the previous 15 years. A lengthy period of very restrictive monetary policy was ultimately needed to stem the high inflation…
– Jerome Powell, ‘Monetary Policy and Price Stability’, Jackson Hole, August 2022

Paul Volcker, appointed Chairman with an explicit inflation-fighting mandate in August 1979 by President Carter, is regarded with almost reverence by many economists and policymakers. A man willing to do the hard thing in the face of severe criticism for the greater good. During Congressional testimony, Jerome Powell called Volcker ‘the greatest economic public servant of the era’. He also quipped that he should have bought 500 copies of Volcker’s recent memoir ‘Keeping at it’ and handed them out at the Fed.

Who were Arthur Burns and William Miller? Good question

While Paul Volcker’s name is relatively familiar, it is unlikely that fellow Fed Chairs Burns (1970 to 1978) and Miller (1978 to 1979) achieve much, if any, recognition. If Arthur Burns is ever mentioned, it’s invariably in a negative context. As former Whitehouse Economic Advisor Kevin Hassett said on WSJ Opinion, “He [Jay Powell] doesn’t want to be Arthur Burns, who let inflation get out of control in the 70s, he understands he has a historic opportunity to be like Paul Volcker…” Contrary to the ruling narrative, there is compelling evidence that the decisions of the Burns and Miller Federal Reserves were as important to ending ‘The Great Inflation’ as those of Volcker.

So what did Arthur Burns do to deserve this reputation? Inflation was moderately elevated before the first Arab embargo sent oil prices rocketing in late 1973, but within a year it had hit 12%. Burns hiked – in fact, he hiked some 9.5 percentage points from the low – taking rates to 13%. The combined shock of higher energy prices and higher rates induced the worst recession seen in the US since the 1930s.

In response to the deep recession, the Burns Fed cut rates some 8% points. Growth returned strongly, but it was soon followed by a resumption of inflation, despite Burns and later Miller steadily moving rates back to 11%. Miller was only in office 18 months before Carter appointed him as Treasury Secretary and Volcker became Fed Chair. Through the Burns/Miller period, real rates – that is, the federal funds rate less the ruling CPI (the black and green lines below) – remained low and were often negative. Contrast this with the high real rates as Volcker squeezed the economy in the period post 1981 (wide gap between black and green lines).

Supply side constraints, what the Volcker narrative totally ignores

The Arab oil embargo of 1973 and the Iranian revolution in 1978 exposed how the US had become very energy vulnerable. Between 1970 and 1978, US production declined some 2 million barrels per day (bpd), roughly 20%. Imports over the same period rose some 5 million bpd (shaded area below). The dependency on imported oil increased from 10% in 1970 to 45% in just eight years. The increasing cost of oil imports had a huge impact on inflation and the economy.

Investment spending upstream and downstream ended the energy crisis
While the huge increase in oil prices ramped up inflation, it also had important second order impacts, acting as a massive incentive for investment spending. Upstream energy capacity expansions, most notably the newly developed Alaskan fields, reversed the US production declines. Similar developments in the North Sea also further increased global non-OPEC oil supply, lowering prices.

Downstream investment also caused a huge reduction in the energy intensity of the US economy. Environmental Protection Agency data shows the average car fleet in 1974 achieved fuel economy of 13.5 miles per gallon (mpg). By 1985, this had improved to over 27mpg, effectively halving the energy intensity of travel. While US manufactured vehicles improved their fuel efficiency, the change was spurred by a huge increase in very fuel-efficient Japanese imports, which grew from 700 000 units in 1975 to over 2.2 million in 1985. For example, the 1974 model Toyota Corolla could do 37mpg.

The combined impact of upstream and downstream investment had a dramatic effect on the proportion of US oil demand coming from imports. When growth recovered in 1984 this had dropped from 45% to between 25% and 30%. The chart below illustrates how the growth or decline in imports, as a percentage of energy consumption, appears to lead changes in the inflation rate.

The strongest investment boom in over 60 years

The price incentives during ‘The Great Inflation’ were not just limited to energy. Rapidly rising wages incentivises capital expenditure by all businesses to reduce their labour intensity of growth, or as economists describe it, improve labour productivity. New machinery enables businesses to achieve the same level of output with fewer staff, or if they can, higher levels of output with their existing employee base. Towards the end of ‘The Great Inflation’, US fixed investment in equipment and structures hit the highest levels in the 75 years of data we have. Yet, this is not mentioned in the Volcker narrative.

Monetary policy and the supply side

The only solution to supply side constraints on an economy is investment. While the market’s pricing signals will incentivise necessary investment, this can be aided or hindered by monetary policy. Higher real rates make investment more expensive and less likely to happen. Fortunately for the US, both Burns and Miller kept real rates low or negative (the shaded area on the chart below), and given the lead times involved, by the time Volcker raised real rates and slowed capex, sufficient investment had been made to de-bottleneck the economy.

The Fed’s own history describes Miller as follows:
"As chairman at the Board of Governors, Miller became known for his expansionary monetary policies… Miller argued that the Federal Reserve should take measures to encourage investment instead of fight rising prices. He believed that inflation was caused by many factors beyond the Board’s control."

We agree, inflation is multi-faceted and complex, a fact not acknowledged by the ‘inflation expectations’ dogma. There is also a sequentiality to solving an inflation problem – until the supply side bottlenecks are resolved (which can only happen through investment), growth without a speedy resumption in inflation is not possible. We see strong evidence that ‘The Great Inflation’ was in fact resolved by the Burns/Miller investment boom, and Volcker’s rates policy would not have been effective without the prior de-bottlenecking of the economy. We contradict the ruling narrative by saying it is clear if Volcker was appointed five years earlier the outcome would have been much, much worse, not better.

Lessons from history

As an analyst it’s important to focus on what policymakers will do, as opposed to what they should do. Fed Chair Jay Powell has made his intentions clear, and can be expected to keep rates elevated to lower inflation by restraining demand in the economy. The US once again has significant supply side constraints to growth, but in stark contrast to ‘The Great Inflation’, the levels of investment are near all-time lows and will be further discouraged as rates remain high. Regrettably, this means any future recovery in growth will be quickly followed by a resurgence in inflation, something not anticipated by the markets (the consensus buys into the Volcker/inflation expectations narrative). Market participants should be aware that in an environment of volatile inflation, long duration assets such as long-dated treasuries and high PE growth stocks have historically provided very poor outcomes.

Aside: Can Powell go ‘full Volcker’ and maintain high real rates through a recession?

The constraints on Fed policy are much more severe now than those faced by Volcker in the early 1980s:

• Government debt to GDP is three times larger (115% vs 38% in 1982) implying substantial increases in the debt service burden from higher rates, especially as the majority of the debt is short dated.
• The budget deficit was just under 2% at the start of 1982 compared to 8% currently. After the Reagan tax cuts and 1982 recession the deficit peaked at 5.3% in 1983. A recession off the current level can be expected to take the deficit to around 15%.
• Financial stability concerns are much higher in a financial sector full of long duration positions and structured credit. What would a 5% or 7% 10-year treasury yield do to the banking system?
• Political backing – Powell has been supported while inflation has been of concern to voters. Should that concern shift to layoffs and unemployment, the Fed will come under immense pressure.