The Bear’s Lair: World central banks are wimping out

The Fed’s decision this week to hold the Federal Funds short-term interest rate at the 5.25%-5.50% range mirrored recent actions in other central banks worldwide. That is a pity; inflation is by no means conquered yet and real interest rates are well below their levels of the United States in 1969, the last time interest rates began to take off and reached current levels. As predicted in this column for two years: central banks worldwide are wimping out before they have conquered inflation — which means we will have it all to do again, while inflation and interest rates will rise much further in the long run.

In the United States, this is a period of massive budget deficits and inflation that has at least stopped reducing in the last few months. We have been here before. The first prolonged spell of U.S. inflation, beginning around 1965 and peaking in 1969, was at least partly caused by Lyndon Johnson’s determination in 1965-68 to fund both the extravagant cost overruns of the Great Society social programs and the equally extravagant cost overruns of the Vietnam War.

He was opposed by Fed chairman William McChesney Martin (Fed. chairman 1951-70 and author of the famous aphorism that the Fed’s job is to “take away the punchbowl just as the party gets going”). However, Martin was a gentleman and Johnson was not, so the stronger willed Johnson was through tantrums able to bully Martin into keeping interest rates lower than he would have liked.

As a result, the U.S. Consumer Price Index rose 4.7% in 1968 and 5.3% in 1969, very similar in total to the 6.4% in 2022 and 3.7% in the 12 months to September 2023 (though the 1968-69 figures included housing costs in full and had no “hedonic” fudge factor, so the true inflation in those years was lower than in 2022-23, whose figures are understated by 1% or so).

The difference lies in interest rate policy. Short-term rates are currently about 0.5% in real terms, taking the average of 2022 and 2023. In 1969 on the other hand, Martin was nowhere near as afraid of Nixon as he had been of Johnson (he was a Democrat and his term in office was due to end in January 1970) so he raised the Federal Funds rate sharply, from 6% in December 1968 to a peak of 9% in July 1969. Real short-term rates thus started at 1% and by July were 4% — much tighter money than we have now.

The same is true in long rates. The 10-year Treasury bond yield is now nearing 5%, but it has not got there yet and its average during 2023 has been only 3.9% — somewhat negative real interest rates in other words. In 1969, the average 10-year Treasury bond yield was 6.67%, or a real 1.7%, almost 2% higher than the current real yield even after the recent yield run-up.

In 1969, therefore, both short-term and long-term interest rates were in real terms considerably higher than today, with about the same inflation. Stock market and economic conditions were strong, with low unemployment, as they are today. The Federal budget ran a small surplus in the year to June 1969 because Congress had put up taxes in early 1968, and a deficit of only $2.8 billion (0.2% of GDP) in the following year. In the year to September 2023 on the other hand, the Federal budget deficit was $2 trillion, almost 8% of GDP, if you account for it properly. Thus, the budget position in 2023, in a near-full employment situation as in 1969, is far more inflation-producing than in 1969-70.

Overall, with inflation about the same, real interest rates were higher and budget deficits much lower in 1969 than in 2023. Yet inflation after 1969 came down only modestly, to 5.8% in 1970, 4.3% in 1971 and 3.3% in 1972 (in both of which years President Nixon imposed price controls) before rising again to 6.2% in 1973 and 11.0% in 1974 – and higher still later in the decade. In other words, even the small deficit and tighter monetary conditions of 1969 did not produce a sustained decline in inflation, even though they did produce a substantial recession in 1970 (which brought the bankruptcy of Penn Central, the nation’s leading passenger railroad).

Interest rates need to go much higher, probably to the 8-9% range on Federal Funds, and stay there for a prolonged period, for inflation to return to its historic 2% target (which is in any case too high – the target should be zero, which would have led the Fed to move more quickly than in 2021-22 when inflation accelerated).

The same is true in other countries. In the Eurozone, the feeble European Central Bank has raised rates only to 4% and paused completely at its latest meeting, with Christine Lagarde, its President saying that inflation would drop in the near-term. In long-term rates, German 10-year euro Bunds only yield 2.8%. While eurozone year-on-year inflation fell to only 2.9% in October, that is probably a blip as core inflation remained higher at 4.2% — inflation in the eurozone had peaked above 10% in 2022. Thus, real long-term rates are still negative, and real short-term rates only around 1%, by 1969 standards nowhere near enough to bring eurozone inflation back within its target range (which again, is in any case too high).

In Britain, Bank of England Governor Andrew Bailey has finally raised short-term rates to 5.25%, after much grumbling and moaning and an entirely artificial market crisis last year that was used (and probably designed) to defenestrate the sensible Liz Truss government. The 10-year gilt rate is however only 4.5%, while inflation was 6.7% in the 12 months to September 2023. Thus, real interest rates in Britain are still sharply negative and Bailey’s optimism that interest rates at these low levels will return inflation rapidly to his target 2% rate is simply delusional.

Japan had the terrible misfortune of a visit from Ben Bernanke when its banking system was falling apart and its central bank in despair in 1998; consequently its monetary policy since then has achieved nothing but prove the folly of Bernankeism, with public debt today around 260% of GDP. Inflation was only 3% in the year to September, but the Japanese call rate is still negative 0.1% and even the 10-year bond rate is only 0.95%. Thus, Japan’s interest rates are thoroughly negative in real terms, and the weakness in the yen, now unprecedentedly low at Yen 151 = $1, suggests that inflation will continue to accelerate, especially as the Bank of Japan under its Governor Kazuo Ueda is still maniacally buying government bonds, under a Yield Curve Control policy whose purpose is inscrutable even by Japanese standards.

All four major “rich country” monetary systems are thus running interest rates still well below the levels at which inflation might be reduced, according to history’s teachings, with U.S. policy being the least over-stimulative of the four and all four central bank governors showing no inclination to continue tightening at this point. The result can only be a continuing upward tendency in inflation rates, since all four economies are operating close to maximum capacity; indeed the U.S. economy may be operating somewhat above it. Productivity growth is also far lower than in 1969, having been badly affected by the decade of zero interest rates; this is another reason why inflation is likely to trend higher than the central bankers forecast.

This column said two years ago that it was likely that central banks would “wimp out” before they had pushed interest rates high enough to control inflation. This is now happening. We must therefore expect at best another decade like the 1970s, with frequent surges in inflation and overall a miserable economy (unless you are an Arab oil sheikh). The worst possibilities, of course, are very much nastier than that. So far, the 21st century has shown no propensity whatever to avoid the worst “tail” outcomes at the grim left end of the outcome distribution curve.


(The Bear’s Lair is a weekly column that is intended to appear each Monday, an appropriately gloomy day of the week. Its rationale is that the proportion of “sell” recommendations put out by Wall Street houses remains far below that of “buy” recommendations. Accordingly, investors have an excess of positive information and very little negative information. The column thus takes the ursine view of life and the market, in the hope that it may be usefully different from what investors see elsewhere.)