The Dawn Of The Great Immoderation

It’s a heretical notion, but I’m compelled to repeat it at regular intervals: It’s the furthest thing from obvious that Paul Volcker’s rate hikes were the proximate cause of the disinflation that came to define the macro environment across developed economies for nearly four decades.

Some have suggested that’s a straw man — that nobody claims that for Volcker. But really they do. Or if not solely for Volcker, then for the combination of Volcker and subsequent policy developments, including the institutionalization of central bank independence and the adoption of inflation-targeting.

I’m going to recycle some familiar language. Time and again I’ve suggested that, when we recap the hyper-globalization years and The Great Moderation, we may give central banks too much credit. In the grand scheme of things — taking account of well-documented trends in demographics, debt and technology, as well as the disinflationary impact of wave after wave of globalization — it’s not obvious that central banks deserve anything more than a polite acknowledgement in a footnote.

When posed as a question, the notion seems almost ludicrous: Is it realistic to suggest that small panels of technocrats were more influential in shaping the macro landscape over a four-decade period than globalization, demographics, technology, offshoring, deregulation and the corporate profit motive combined?

To me, that seems laughably implausible. And yet analysts and economists make that argument every, single day in one form or another. In fact, it’s the accepted version of events.

It’s through that lens that I’d implore readers to consider ever higher projections for the Fed’s terminal rate this cycle. “It’s not what I would expect but it would not surprise me if the terminal rate reached 6% more,” Larry Summers told Bloomberg Television’s David Westin, for this week’s installment of “Wall Street Week,” which the network seems to imagine is as popular among market participants as SEC football is to college sports fans.

Summers isn’t alone. This week found the market ratcheting terminal pricing higher in and around the November FOMC meeting, after which Jerome Powell put a decidedly hawkish spin on the ostensibly dovish “step-down” narrative. The Fed will almost surely hike in smaller increments going forward, but to a higher destination. The figure (below) shows how expectations have shifted.

Again: It’s higher for longer. The question, as Powell made abundantly clear, is “How high?” and then, later, “How long?” to hold terminal.

But maybe those shouldn’t be the questions. Some regular readers might be tired of hearing this, but it’s possible that central banks simply aren’t capable of controlling inflation. If The Great Moderation was an anomaly, not the dawn of a new epoch, then macro volatility, like geopolitical tumult, was destined for a reset to the historical norm, which I’ve suggested is something akin to chaos.

Between the pandemic and the war in Ukraine, virtually every disinflationary enabler that helped keep price growth subdued for three decades is in retreat. Some of those enablers had deleterious societal side effects which were likewise disinflationary, including the decimation of labor as an economic actor with clout. Those side effects eventually manifested in a restive electorate which, in turn, opened the door to populism on both the political right and left. The right’s agenda is inflationary through nationalism, isolationism and exclusion (e.g., less immigration, less globalization, etc.). The left’s agenda is inflationary too, through untargeted public spending, the re-empowerment of labor and the subjugation of price growth concerns to a more literal definition of “full employment.” You might like the populist right’s agenda. Or you might like the populist left’s agenda. It doesn’t matter for this discussion. Both are inflationary.

Given the above, and considering that, as Powell has admitted, economists actually don’t know that much about what causes inflation and can’t scientifically measure the extent to which expectations for price growth are becoming unanchored, the notion that central banks are absolutely capable of controlling inflation with rate hikes seems a dubious proposition, at best. At worst, it might be absurd.

You could argue that money supply growth is receding, and thereby the monetarist view suggests inflation is poised to retreat, but that’s not an argument for central bank control given that modern central banking abandoned monetarism a long time ago. And besides, I’m not convinced that reining in the money supply is going to do the trick in the presence of geopolitical chaos. There will always be too much money chasing too few goods if the supply of key goods is subjected to unpredictable and severe disruptions due to geostrategic concerns or, less politely, war.

The figure (below), shows UK inflation going back to 1200. Suffice to say it’s been a turbulent ride.

I suppose you could say the last century (give or take) represents an improvement, at least in terms of the absence of deflationary busts. But I’d gently suggest that what the chart shows isn’t any miracle of policymaking, but rather just the evolution and modernization of economies as the world moved away from primitive economic and societal arrangements and abandoned systems subject to various constraints (e.g., precious metals).

Obviously, a return to the sort of spectacular macro volatility that characterized centuries past isn’t especially likely, but it’s entirely reasonable to suggest that a return to a pre-Great Moderation, pre-Pax Americana state is not only possible, but probable. Indeed, there’s a sense in which this is tautological. The Great Moderation is over. So, apparently, is Pax Americana. Why would macro volatility not revert?

There are any number of catalysts that could render monetary policy even more impotent vis-à-vis inflation than it’s proven to be over the past 18 months. If China moves to seize Taiwan, all bets are off, for example. Already, the economic cold war between the US and China is contributing to inflation. But on a grander scale, beyond just the chips and the tariffs, hot wars are inflationary.

All bets are similarly off if NATO is compelled to forcibly expel Russia from Ukraine. I’m not sure this is well understood by many market participants, but occupation in perpetuity on any scale larger than Crimea is a non-starter. Disputed territory controlled and administered to a greater or lesser degree by separatists is suboptimal, but arguably tolerable. By contrast, the current state of affairs, wherein the same territory is annexed and occupied, won’t work. One way or another, Russia is leaving Ukraine proper. It’s just a matter of when and how. Already, the conflict is contributing mightily to inflation via the impact on commodities. But on a grander scale, beyond “just” the oil, gas and grain, hot wars are inflationary.

Finally, note that Donald Trump is reportedly poised to announce his candidacy for the GOP presidential ticket after the US midterms. There’s no reason to believe he’d lose the Republican primaries, and every reason to believe he’d dispute a lost national election. It isn’t out of the question that some members of the US military would support Trump in any such dispute. In my opinion, there’s a non-zero chance that one way or another, the US ends up temporarily run by the Pentagon in early 2025, either due to the successful defense of democracy or the opposite. In such a scenario, trading and settlement of US Treasurys could be subject to disruptions, with unknowable implications for the dollar and near-term inflation expectations. Already, division, acrimony and hopeless partisan rancor are contributing to inflation. But on a grander scale, beyond just the inability to legislate cooperatively to assist the central bank in its efforts to corral price growth, hot (civil) wars are inflationary.

I haven’t heard anyone other than perhaps Zoltan Pozsar suggest that inflation may be largely stochastic going forward, and thereby wholly beyond the capacity of central banks to control. But when you think about how volatile the world is in 2022, and how volatile it’s likely to be for at least another few years, you’re left to wonder how anyone could seriously countenance the notion that a handful of technocrats with no authority to negotiate trade deals, peace deals or fiscal policy, are capable of singlehandedly pulling inflation back lower, let alone managing it in a tight band around an arbitrary target with no help from anyone or anything other than a thoroughly discredited pseudo-science.


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19 thoughts on “The Dawn Of The Great Immoderation

  1. I am greatly appreciating this attempt to juggle the moving parts of the puzzle that will be debated for generations to come. I am certain a lot of Readers here at H……Report do exactly the same and mostly from the Right Side of the Bell shaped curve for IQ .
    The issue in topics as highly subjective as this one is the values one places on the competing moving parts are what drives the End Assessment . There is no help for anyone on that issue except Life experiences and Intuition as well as the omnipresent role of History . It is interesting to learn from Others and watch their struggle with this issue irregardless of whether or not one agrees with the thought process or not….. My personal attempts tend toward Simplification as opposed to Over Complication . Both are Risky !!

  2. This sort of article is exactly why I subscribe. Thank you for emphasizing macro themes that challenge the prevailing narrative.

    There are also some micro developments which may raise inflation expectations in the near term. This burgeoning diesel shortage in the US could be a big deal, not just for commerce (which is rather dependent on the stuff) but also for heating costs in the northeast. Also, apparently the railroad contract agreement (that narrowly avoided a strike a month back) is at risk of falling apart (apparently 3 of the 12 unions voted against so far, with two big votes coming up). One wonders, with the polls increasingly showing GOP likely to control Congress, are union leaders more likely to push for a strike now while they still have a sympathetic ear in Washington ? Would love to hear others’ thoughts on this.

  3. I used to think that what was beginning to happen, in the modern era, 100 plus years ago could never be repeated; that a better educated and informed populace would eventually prevent maniacal tyrants from gaining the absolute power they desired. That somehow logic, diplomacy, and the abhorrence of extinction would slowly, but surely, lead to some type of relatively peaceful global coexistence.
    Boy, was I mistaken.

  4. I agree with your central thesis, that global economic forces have been more impactful on inflation than individual or collective central bankers. It’s interesting to pause here momentarily and reflect on why the Common Man (I expect the Common Woman isn’t so deceived) thinks otherwise.

    Reflecting deeply for 30 seconds, I think it may reflect the Great Man (it’s always Men, right?) of History fallacy. It’s simpler, lazier, and reflective of human biases to anthropomorphize history rather than to take the time and effort to understand the historical forces that puppeteered these Great Men. Likewise with inflation and central bankers.

    Parenthetically: the transition from fossil fuels is likely to be highly inflationary, assuming that Western voters are willing to pay the price and forgo the occasional steak and latte for the sake of future generations. This presumption is at the very least questionable given that the US electorate values steak and lattes more than Democracy. The 2022 MAGA slogan: “thou shalt not crucify Mankind upon a cross of solar panels”?

    Double parenthetically: ending beef consumption would be multiple orders more efficient than transitioning to fossil fuels, but the farming lobby and beef lovers would never permit it; it would also violate the right to eat beef, which is enshrined in the 28th Amendment to the Constitution.

    Returning to the Great Man of Economic History fallacy: if you are willing to concede that, as with political leaders, we get the central bankers that we deserve, we may well end up with raging inflation AND lower rates. Sacking Powell will be the first Presidential act of our next leader, regardless of political affiliation, because voters will demand it. After all, blessed with the patience and petulance of a toddler, they won’t want to sacrifice their steak and lattes for the sake of economic heterodoxy or some uncertain future benefit.

    1. Biden’s biggest blunder to date was not sacking Powell thereby losing the golden political opportunity to tie Powell both to inflation and Trump…and the dems may suffer enormously because of it…and of course the deer in headlights response to MBS reducing oil supplies last month hasn’t helped the cause or case…just saying…

      1. Correct on both counts. I had not considered that. Sacking Powell could have been helpful for sure, if only from the perspective of at least trying to deliver some form of messaging. Deer in the headlights clearly describes Biden’s fumble with MBS, whose actions lately seem to be openly hostile to the US. MBS and the Saudis will get a response, I expect. But it may surprise them when and how it comes.

        I’m concerned Biden is over his head. He (and the staff who assist him) are terribly lame in messaging about most everything. In addition to opening himself up to a figurative slap from MBS, Biden’s staff has been remiss in using its messaging capacity in support of Biden’s goals and accomplishments. When useful and appropriate, they should also use the presidential platform to meaningfully and directly respond to the right by directly endorsing and promoting candidates to positively impact policy.

  5. I’m going to respectfully disagree and say that until it’s proven that CBs can’t control inflation with rate hikes, the jury is out. That said, for the reasons you’ve outlined, it may take 2-3 years for the Fed and other CBs to get this inflationary episode under control.

    1. If Europe has insufficient gas to meet people’s power generation needs, and they reach the absolute lower limit in terms of rationing (i.e., the lower bound beyond which people will risk literally freezing if they ration more or the point beyond which German industry literally can’t function), and no additional supply comes online, how many ECB rate hikes will it take to bring down gas prices? There’s no reducing demand beyond that level, because that’s the level beyond which people and industries die. So that level of demand will always be there. If supply can’t meet it, and the shortfall persists, so will inflation, irrespective of what monetary policy does. Germans need gas to keep warm and the German economy needs gas to keep functioning. The ECB can hike rates to 10,000% and it won’t “fix” that basic reality. There’s only so low demand can go for certain goods and services. Once rate hikes “succeed” in taking demand down to that level, that’s the end. Absent additional supply, inflation will spiral to infinity. Or people and businesses will die. Or both.

  6. Did demographics change? Seems most of developed world keeps getting older and having fewer babies … we were told that ala Japan, demographics bigly drive inflation, growth. Nothing in the demographics have changed materially that I’ve read. So the other forces are stronger and demographics aren’t that important, or … maybe it was a straw person narrative that wilted after it no longer work. Seems that in all the inflation talk aging humanity has fallen away.

    1. Seems to me what’s changed is the mobility/globalization of human capital, which contributed to the disinflationary forces. Separately, earlier this year i read a view which stated that demographics is actually an inflationary factor now, through reduction of labor supply (while the retirees continue to consume)…

  7. Good idea to have a watchlist of asset classes, sectors, industries, etc that you think will work in an environment of sustained high inflation. If investors increasingly doubt CB’s ability to control inflation, those names will start to outperform. And conversely, if those names start to outperform, that will be a clue that investors are increasingly doubting.

  8. Let’s also not discount the role a changing climate will play. When there’s less water in the Mississippi River, transportation costs increase. When hurricanes level whole regions, construction costs and insurance premiums rise. When climate change impacts species survival, as appears to have happened to the snow crab, prices may rise to infinity because the species we consume for sustenance no longer exists and can’t be bought at any price.

  9. Outstanding effort, H…you want influence from a small group how bout 19 men on 9/11/2001 (15 Saudi nationals) who forever influenced history armed only with the element of surprise and a willingness to die for their cause. 20+ years later, two endless and unwinnable wars, trillions dollars, more human good will wasted, and here we are…

    …as for the inflation issue given the current environment Central Bankers actually stating and believing a return to a stable 2% level is preposterous to me as I see food, energy, and commodity prices staying higher for longer…GLTA…

  10. Great point, Heisenberg. Pax Americana rings true. I wasn’t thinking along that line. But it’s a realistic description of the current state of the world.

    You’re also correct about the “what if” scenarios going forward. The invasion of Ukraine is the most obvious and immediate area of challenge to the Pax Americana. Beyond Europe, Eastern Europe and certain far-east destinations reveal broader ongoing risks.

    Globalization lingers but has certainly been tempered by recent changes in the balance of world economic and military power. A couple of facts worth noting:

    China has the world’s largest navy (355 naval vessels and counting).
    Australia is adopting American nuclear submarine designs for its navy,
    which will greatly enhance its strategic value as a check on China.
    The island nation of Japan has quietly over the years built one of the
    strongest navies in the world.

    The preparations by the navies of Japan, Australia, and the US in the Pacific match numbers and strength to meet any challenge the Chinese might present. It’s a costly exercise that requires only simple math. But the world never remains the same. I cannot help wondering to what extent foresight about the end of globalization, and the inevitability of political power rebalancing in the world may have played in the calculations.

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