Forrest Gump, Paul Volcker and Expected Inflation
Traveling around Europe this summer, my friend said to me: "You're like Forrest Gump. You've been with key people at major world events."
Hmmm...
Yes, I've worked for (former - pardoned) felon Michael Milken, experienced Black Monday (stock market down 20% in one day), the dot.com bust, uncovered the Enron scandal... and I run... alot.
My friend may be right.
But inflation? The last time we saw that was in the 1970s when I was 10 years old... and yet... you guessed it... I have a story for you!
September 2008... I was having lunch with Paul Volcker in Schloss Leopoldskron in Salzburg, Austria. Multiple lunches. And dinners.
How and why did I end up hanging out with Paul Volcker the weekend Lehman went under?
Backing up a bit...
My mother was an award-winning screenwriter. She died when I was 24. When I had time and money to travel, I set out to meet the people in her life and write a book on her.
I met Bill Yates, a former member of British Parliament, then living in Australia.
My mother worked for Bill while she attended grad school at Oxford, when he was in London. He told me the Salzburg Seminar had changed his life, and he would sponsor me.
I was like a cat pulling on a string...
In 1997, I was one of 2 Americans accepted to the Salzburg Seminar's Rise of Industrial East Asia and Implications for the Developing World. Highlights include breaking into Schloss Hellbrunn with trick water fountains on the day it was closed, with Singapore's Ambassador to the EU, under his diplomatic immunity (which did not extend to me).
My mother broke into castles by swimming across their moats when she lived in the UK, so I was just following her lead.
Fast forward to 2008
I return to the Salzburg Seminar for a 5-day course on Sovereign Wealth Funds (money run by and for large governments). Paul Volcker was leading the course.
I didn't care about the topic. I wanted to meet Volcker. I wasn't disappointed.
This course went from September 12-17, 2008.
Lehman negotiated for its survival over the weekend (September 13-14, 2008), and declared bankruptcy Monday, September 15, 2008.
That weekend Lehman Bros went bankrupt and nearly crippled the world's financial system.
I was hanging out with Volcker for those 5 days!
The CFO of Citigroup was there. He left on the first day, Friday, in a panic.
Obama was the incoming president. He called asking Volcker to come back to the US immediately. Volcker refused:
"This is why I am an advisor and not an incoming cabinet member. I am leading this conference and then going on a cruise down the Danube with my lady-friend next week." Volcker said to Obama.
He then shared with me some choice words on the Lehman situation (perhaps I'll share those another time...)
Obama's loss was my gain.
I sat next to Volcker for multiple meals and got his thoughts on investing:
Never invest in something you don't understand (credit default swaps were the flavor of the day then and derivatives of CDSs, derivatives on derivatives on mortgage portfolios, and the uneven bankruptcy laws around the world were what nearly took down the financial systems)
Never underestimate second order unintended consequences (ie even if you think you understand an investment, you might not understand its interaction with other investments).
Never let your guard down on inflation (it's not the price increases but human psychology, those second order effects, that we don't understand. If we don't understand an individual person, how can we pretend we understand human psychology in aggregate?)
Volcker died 11 years later on December 8, 2019.
I remember being sad. He was a humble, very tall, and intelligent man.
I also remember being glad he didn't see what the Fed was starting to do next. Before Covid, they already started pushing a new concept (they called it Modern Monetary Theory or MMT) of thinking they had the power to drive growth in the economy by increasing inflation.
Inflation does not equal growth. It's only growth in prices, not growth in underlying demand. Even in the case of hoarding, you buy ahead because you expect higher prices, but you are moving your purchase from one time period to the next. That is not economic growth.
When Covid hit, the Fed really put the gas on driving up inflation because they thought higher prices were a proxy for economic growth.
Nuts. Yet...
Investors, and people, have short memories.
The 1970's were the last time we had serious inflation.
When semiconductor (semis have shorter faster cycles than the economy, so they are a great way to learn about cycles without waiting 20 years) executives would talk about a slight softening, but we all knew we were headed for a downturn, I asked why. They'd say: "Emmy, my job is to keep stock prices up. These are new analysts. They don't remember the last downturn."
That's the same issue with inflation.
Yes, it's a pain to pay 30-50% more for gas vs last year, but most of us can reallocate or save less.
We notice inflation but don't worry about it the way Volcker did.
Because we don't understand how inflation gets embedded in our minds.
In 1979, Volcker was brought into the Fed to fight inflation, which had gotten embedded in the public psyche during the 1970s, especially with the 1973 and 1979 oil price shocks. The economy had stagnated for a decade but inflation was still high (this is called stagflation) because it was in the public psyche no matter how slow the economy was growing.
Volcker raised the prime interest rates to over 20.5% by December 1980.
The prime rate is what all other loans price off of. Your credit cards charge 5-15% above prime. Mortgages are 2-3% above prime with good credit.
In 1980 I had a bank savings account that paid me 22% interest.
Most people are payers (mortgages and credit cards) not savers. High interest rates led to nationwide protests, 11% unemployment and a deep recession from 1980-1982. All these were self-inflicted via higher interest rates.
Volcker never wanted to see that much pain again, so he believed we needed to remain vigilant about inflation and its unintended consequences.
Why is inflation hard to fight?
It's all about expectations.
Inflation = Price Increase + Expected Price Increase
I learned this in my MBA at USC in 1992.
You know what?
Like a real live conspiracy theory, that formula has disappeared from Google. Google says inflation is the year over year percentage increase in price.
If that were the case, then we could just increase supply, and prices would come down. Supply chains would normalize post-Covid and we'd go back to 2% inflation and be done with this phase.
If that were the case, the brilliant Paul Volcker wouldn't have worried so much.
How do expectations get embedded into inflation?
Car prices go up 30%. Maybe you put off buying a car. That should help the demand/supply picture. But other people might need a car (thus supporting that price) or they may worry next year if prices go up again, they won't be able to afford a car.
So they buy.
The next year car prices go up 50% because more people worry that another year of this and they won't be able to afford a car.
So they buy.
Same with food. Anything that can be stored, people start to buy ahead. Hoarding starts. Driving prices up further.
Prices going up reconfirms our expectations that pricing will go up again.
Prices going up encourages hoarding and buying ahead which drives up prices and also drives up the expectations of prices going up the next year.
Thus price increases can go up 30%, then 50%, then 80%, then 120% as the years go by. Increasing at an increasing rate as prices increase hoarding and the expectation for higher prices which increases hoarding and prices, and this cycle repeats.
Think this can't happen? When Germany lost World War I, they had issued a lot of debt and started printing money to pay it (simplified version - but real interest rate = interest rate - inflation, so many governments try and reduce their debt load via higher inflation).
In 1922, Germany's inflation, or prices, went up 17X in 7 months. My 120% inflation example above looks mild.
If inflation is a fire, expected inflation is gasoline added to the fire.
Ever tried to convince someone something is not true? Convince a doomsday planner they don't need supplies? Convince a scared person they are safe?
Fighting inflation is not about supply and demand.
It's about fighting a belief that is quickly getting embedded in the American psyche. That prices are going to go up. We expect future inflation.
I don't have the answers.
Paul Volcker was a kind and gentle man. Very smart. He spent his life in government service. He didn't want to create a recession. But he felt he had to.
It may be the only way to get expected inflation out of our psyche is to shock the system. High interest rates do that. When interest rates are high enough, we stop buying houses. We stop spending with credit. It's no accident that Germans still want to buy everything with cash, not credit.
Recession and downsizing take over our psyche.
This is a global issue. Germany just reported 10% inflation. And it makes sense. Covid was global. And central banks around the world all pushed to grow inflation at the same time.
The Volcker I knew would shake his head and sigh.
Here we go again.
The question in my mind remains: does the Fed of today have the political stomach and/or political capital to do what Volcker did?
Volcker came in after a decade of inflation.
The US government tried all the other more palatable options. Then Volcker went nuclear, and it still wasn't easy. He had to deal with death threats and nationwide protests.
So, in today's always on, social media, cancel culture, could any Fed chair survive politically long enough to do what Volcker did? Or will the current recession kill off inflation?
I don't know, but it may not be pretty finding out.
For an idea on where we might go, Ray Dalio wrote How Inflation, Interest Rates, Markets and Economic Growth Relate. He is one of the great macroeconomic thinkers of our time.