Gravity works to contain inflation unless central banks match it with expanding money (with currency collapses and hyperinflation, as in Germany and Austria after WWI). Price increases reduce the purchasing power of the money supply and activity weakens.
The 1939-1949 inflationary period is more comparable to events since the 2008-09 recession than to the 1970s episode (Burn’s Fed and falling productivity growth). This is because the chain of events of the 1930s and 1940s also followed a financial crisis and deflation, which then led to a quantitative easing response.
Inflation followed from Franklin D. Roosevelt’s handling of the 1933 banking crisis – just as current issues began with the 2008 global financial crisis.
Roosevelt believed that the depression could not be reversed without turning deflation into inflation. Similarly, the Fed’s post-GFC goal was to avoid outright deflation and bring inflation back above 2 percent.
FDR temporarily closed the banks, making it illegal for individuals and banks to own bullion. Gold was relinquished and its ownership transferred to the Treasury Department, which issued gold certificates to the Fed.
He then devalued the dollar against gold from $20.67 to $35 an ounce in 1934 (a massive shift). Gold flowed into the Treasury and the Fed’s balance sheet grew due to the size and value of gold certificates. As a percentage of GDP, the balance sheet was already increasing due to the collapse of the denominator (nominal GDP fell 45 percent from 1930 to 1933). After that it increased significantly.
The Fed’s balance sheet rose to about 28 percent of GDP by the end of 1940, despite a sharp reversal and an increase in the GDP denominator. From 1934 to the end of World War II, real deposits in the hands of households grew by 159 percent.
US inflation rose to 10 percent by 1941. FDR imposed price controls for the war and curbed inflation. But when price controls were removed, inflation exploded with the release of pent-up demand and post-war (like post-COVID) tightening. Inflation reached 20 percent in 1947.
Inflation followed from the way Franklin D. Roosevelt dealt with the 1933 banking crisis.
Inflation fell for two main reasons: the gravitational pull of the falling real value of money (down 28 percent from December 1945 to December 1948); and the rapid reversal of the FDR budget’s record deficit to surplus in 1946 (Harry Truman was a fiscal conservative).
The US economy entered a recession in 1949.
The lessons of this period for the current political dilemmas and prospects are worth noting.
First, pumping up the Fed balance sheet in a way that puts money in the hands of the public on a large scale, whether through gold certificates or COVID checks, will cause inflation.
Second, artificial restraints like price controls or COVID lockdowns only delay the inflation outcome.
Third, the mystery of how the Fed’s balance sheet was normalized as a percentage of GDP is revealed: The Fed did not reduce the dollar amount of its balance sheet after the war. Inflation over a long period reduced it as a percentage of GDP.
Fourth, the sudden implementation of fiscal tightening plays a key role in recessions and deflation.
Fifth, if inflation’s destruction of purchasing power is left unaddressed, it will starve demand and slow the economy.
Against this backdrop, how might things play out in 2023 and beyond for bond and stock investors?
There will be no fiscal contraction under Joe Biden like there was under Truman. The US still has a large budget deficit. The fiscal turn from 18 percent of GDP to 5 percent reflects the end of COVID restrictions and handouts as people went back to work.
The labor market remains stable.
Gravity has started working on real money balances. US bank deposits as a percentage of GDP accounted for 60 percent of GDP in January 2019 and rose to 77 percent by 2021. With past inflation, the stock is still up 65 percent today. Gravity doesn’t bite yet.
The Fed balance sheet has not fallen at this point. The national debt is also relatively high. There must be some temptation to let inflation run longer by easing interest rates. The FDR way of reducing the Fed balance sheet is simpler than selling Fed assets and creating a bond routine.
Real interest rates are still negative. Mortgages in the US are mostly fixed rate. When nominal interest rates rise, existing borrowers do not change their mortgages. It will be a long time before interest rates only affect new loans.
Financial markets should therefore brace themselves for higher interest rates for longer than previously expected, as there are no factors that could cause a sharp slowdown. The reasoning here suggests a greater likelihood of stagflation.
Not great for bonds or stocks.
Comments are closed.