Three Financial Challenges for the United States in 2024
Inflation, War, and Unsustainable Spending
Dear Readers,
I apologize for the extended hiatus from writing this newsletter. The February 27, 2024 launch of Investing in U.S. Financial History: Understanding the Past to Forecast the Future was time intensive. The promotion process entailed conversations with more than 15 podcast hosts, hundreds of attendees at virtual and onsite venues, dozens of members of the media, and quite a few readers. Overall, I am excited to hear that the book is fulfilling its intended purpose. For those interested in reading or listening to recordings of a few select events, links can be found at the bottom of this newsletter.
Financial Challenges in 2024
There are numerous financial challenges that the United States now faces, but there are three that warrant the most attention. The first, which is admittedly obvious, is the persistence of post-COVID-19 inflation, and the Federal Reserve’s monetary response. The second is the risk of unintended escalation of regional wars in Ukraine and the Middle East, which would inevitably have financial consequences. The third is the persistence of fiscal deficits in the United States and the clearly unsustainable increases of debt issuance required to fund them.
The drivers and potential consequences of each challenge can be understood at a deeper level by reviewing multiple historical parallels and the lessons learned from them. The remainder of this newsletter focuses only on the first challenge: post-COVID-19 inflation and the Federal Reserve’s response. The remaining two challenges will be covered in forthcoming newsletters over the next month.
Challenge #1: Post-COVID-19 Inflation and Monetary Policy
Post-COVID-19 inflation began in the spring of 2021, and it took many economists, investors, and even the leadership of the Federal Reserve by surprise. This is unfortunate because a thorough review of financial history revealed that a strikingly similar event occurred after World War I and the Great Influenza ended simultaneously. The Federal Reserve was similarly caught off guard by the unanticipated inflation in 1919, and they failed to tighten monetary policy until January 1920. But when the Fed acted, they acted aggressively by initially raising interest rates by 125 basis points and then another 100 basis points in June 1920. This triggered a deep but relatively brief recession of 1920-1921.1
The post-COVID-19 inflation initially followed a similar path beginning in the spring of 2021 (see Figure 1). At first, the Fed mistakenly believed that the increase in inflation was entirely a function of supply chain disruptions, which explains why they mislabeled it as “transitory.” But by late 2021, inflation remained at elevated levels, and the Fed acknowledged the error of their initial assessment. Then, the Fed signaled that a much more aggressive tightening of monetary policy was forthcoming.
Beginning in February 2022, the Fed initiated a series of interest rate hikes. Over the two years that followed, inflation declined to a more tolerable level—but it remained well above the long-term target of 2%. By the fall of 2023, many market participants—and even several members of the FOMC—expressed growing confidence that the United States was on a “golden path” that would end with a return of price stability without a recession. In other words, many believed that the U.S. was heading for a soft landing.2
Figure 1: 12-Month Trailing Inflation and Cumulative Increases to the Federal Funds Rate for Post-World War I/Great Influenza and Post-COVID Inflation.
The Fed Discounted an Important Lesson from the Great Inflation
“The simplest [lesson from the Great Inflation] is this: Inflation if it reemerges, ought to be nipped in the bud; the longer we wait, the harder it gets to reign in.”3
ROBERT J. SAMUELSON, Author of the Great Inflation
In December 2023, several leaders at the Federal Reserve expressed their belief that a pivot toward more dovish policies was likely in 2024. In the Federal Reserve’s December 13, 2024 Summary of Economic Projections (SEP), the median expectation was that the Fed would cut rates by approximately 75 basis points in 2024.4
The problem with this projection is that it discounted a critically important lesson from financial history that strongly suggested that the dovish shift was premature (see this December 2023 LinkedIn post that explains why). This is because loosening monetary policy too early risks far graver consequences than maintaining restrictive policies for too long. The biggest risk of cutting rates prematurely is that it could create conditions that would cause inflation to reignite. If this were to occur, the Fed would lose credibility, which would make it more likely that elevated levels of inflation expectations could become entrenched in the economy.
The premature abandonment of monetary policy was a major cause of the Great Inflation of 1965-1982.5 The Fed made this error on several occasions, and each time inflation returned at an incrementally higher level. Further, the American public lost faith in the Fed’s commitment to maintain price stability, which allowed higher inflation expectations to become entrenched in the psyche of Americans. Even worse, the anticipated trade-off of lower unemployment in exchange for higher inflation broke down. This phenomenon was referred to as the vertical Phillips curve, and it is one of the hallmarks of the Great Inflation. In simple terms, this meant that Americans suffered from both high inflation and high unemployment. Figure 2 captures these three elements of the Great Inflation. The blue line (left axis) shows the Federal Funds rate; the red line (left axis) shows 12-month trailing inflation; and the gray area (right axis) shows the rise of unemployment.
Figure 2: Monetary Policy, Inflation, and Unemployment during The Great Inflation of 1965-1982
A Reverse Pivot to “Higher for Longer”
“We’ve said at the FOMC that we will need greater confidence that inflation is moving sustainably toward two percent before it would be appropriate to ease policy…The recent data have clearly not given us greater confidence and, instead, indicate that it is likely to take longer than expected to achieve that confidence.”6
JEROME POWELL, chairman of the Federal Reserve Board (April 16, 2024)
In 2021, the Federal Reserve overlooked an important lesson from the post-World War I/Great Influenza inflation of 1919-1920. The good news is that they seem much less likely to overlook the lessons of the Great Inflation if only because several voting members of the FOMC, including Chairman Jerome Powell, remember the painful experience and the important lessons. In fact, Chairman Powell often references the most important lesson, which is that monetary policy tightening cannot be abandoned prematurely. For example, in his press conference on January 31, 2024, Chairman Powell made a clear reference to this lesson when he stated, “We know that reducing policy restraint too soon or too much could result in a reversal of progress we’ve see on inflation and ultimately require even tighter policy to get inflation back to 2 percent.”7
Over the past few months, speeches by Federal Reserve presidents, such as Neel Kashkari, Christopher Waller, and Loretta Mester, have reinforced the Fed’s reversal of its prematurely optimistic forecasts. Even Austan Goolsbee—who delivered a speech in September 2023 in which he flirted with a declaration that a soft landing was “mission accomplished”— has adopted a more hawkish tone. Finally, on April 16th, Chairman Jerome Powell reinforced the return of a more hawkish outlook when he specifically stated that recent data has not given the Fed confidence that inflation has been decisively tamed (see quote above).
Likely Consequences (but Uncertain Timing) of Prolonged Monetary Policy Tightening
“There is a prudent maxim of the economic forecaster’s trade that is too often ignored: Pick a number or pick a date, but never both.”8
PAUL A. VOLCKER, former chairman of the Federal Reserve Board
Investors would be wise to believe that hawkish policies will prevail in the U.S. until the Fed is confident that price stability is reestablished. Financial history strongly suggests that gaining this level of confidence will require economic pain in the form of a recession and material weakening of labor markets. This happened in 1920-1921 in the aftermath of World War I and the Great Influenza. It also happened in the early 1980s when Chairman Paul Volcker’s draconian monetary policies ended the Great Inflation and reestablished the Fed’s credibility.9
Even though most economists and investors were proven wrong when they forecast a recession in 2023, that does not mean that the risk of a recession has disappeared. It may just be that the timing of the forecast was off. The difficulty of correctly forecasting the “number” and “timing” of an economic event is the perennial challenge to which Paul Volcker referred in the above quote. Thus, despite the inaccurate timing of prior market forecasts, financial history still strongly suggests that the “number” that will describe economic growth before post-COVID-19 inflation ends will be negative. When this will occur is much more difficult to predict—if it is predictable at all.
In conclusion, recent economic data confirmed that the December 2023 tilt toward dovish policies was premature, but the Fed’s commitment to reestablishing price stability appears to be intact. This may be unwelcome news to investors in the short term, but it is a cost worth incurring to ensure prosperity in the long term. To that end, long-term investors, who correctly pay little attention to short-term market volatility, should be relieved by the Fed’s reversal of its premature pivot.
Highlights from Launch of Investing in U.S. Financial History
Below are links to webinars, podcasts, and media commentary that may be of interest to subscribers.
Media Commentary
Webinars
Museum of American Finance - “Overview of Investing in U.S. Financial History and Key Lessons.”
Podcasts
CFA Institute’s Enterprising Investor - “Lessons from U.S. Financial History.”
Excess Returns - “Lessons from Financial History: Inflation, Bank Failures, Bubbles, and More.”
Library of Mistakes (Russell Napier) - “Investing in U.S. Financial History.”
Disclaimer: This is a personal newsletter. Any views or opinions expressed herein belong solely to the author and do not represent those of any people or organizations that the writer may or may not be associated with in a professional capacity, unless specifically stated. This is not to be construed as an offer, solicitation, recommendation, or endorsement of any particular security, product, service, or considered to be tax advice. There are no guarantees investment strategies will be successful. Past performance is no guarantee of future results. Investing involves risks, including possible loss of principal.
The underlying causes of this inflationary event are covered in chapter 14: War and Pestilence of Investing in U.S. Financial History.
The “golden path” was a phrase that was specifically used by Austan Goolsbee, president of the Chicago Federal Reserve bank, in a speech on delivered on September 28, 2023 at the Peterson Institute for International Economics.
Robert J. Samuelson, The Great Inflation and Its Aftermath: The Past and Future of American Affluence (New York: Random House, 2010).
“Summary of Economic Projections.” Federal Reserve Board. (December 13, 2023).
The underlying causes of the Great Inflation are covered in chapter 23: Inflated Expectations of Investing in U.S. Financial History.
“Transcript of Chair Powell’s Press Conference: January 31, 2024.” Federal Reserve Board. (January 31, 2024).
Paul Volcker and Toyoo Gyohten, Changing Fortunes: The World’s Money and the Threat to American Leadership (New York: Times Books, 1992).
To be clear, however, the severity of the 1981-1982 recession seems unlikely to repeat because inflation expectations remain anchored in 2024.
This is brilliant and well written.
Thanks for the insight!