Henry Kaufman and hitting the market in the face

Henry “Dr. Doom” Kaufman, former Goldman economist, still working (in his own firm) while his personal odometer approaches three figures, was perhaps the most important Fed interpreter on Wall Street during the Paul Volcker era.

In a “recent” interview with the Financial Times, published yesterday, Kaufman compares Jerome Powell’s performance as head of the Federal Reserve unfavorably with that of Volcker in the early 1980s. The former, in Kaufman’s view, has so far only slapped the financial markets on the hand, in a situation where the latter did what was needed and punched them in the face.

Ultimately, no one is going to buy fixed income instruments unless they, at a minimum, preserve the real value of the owner’s purchase. As Kaufman put it, interest rates need to be higher than inflation. Yes, the 10-year Treasury yield has moved from 1.6% on New Year’s Day to as high as 3.5%, before a recent decline to around 2.9%. That’s a long distance from its March 2020 low of 0.54%. Fed Funds are at 2.5%. But headline inflation is at 8%. Therefore, either inflation comes down or rates have to go up.

I think this last is exactly correct. If we imagine that the long-term inflation target is 3%, then the 10-year should end up somewhere in the 4%-5% range, depending on what investors determine the real return should be.

I think the current situation is substantially different from the 1970s, however. So while a stern expression and a harsh voice may be needed, I wonder whether a punch in the face is the wisest course.

The differences I see:

–for the 1970s as a whole, yearly inflation averaged just under 7%. This strengthened the belief back then that inflation was an enduring phenomenon. Certainly, a lot of loony things happened in the late 70s, as inflation began to accelerate–like lots of industrial companies borrowing heavily to buy gold mines (thinking the real value of fixed-rate debt would decline while gold would only rise) or to explore for the newest super-metal, molybdenum. Yes, this was really stupid, but it shows how panicked even the adults in the room were about accelerating inflation. In contrast, the great macroeconomic fear of the past two decades has been that the Fed’s best efforts have been unable to get inflation to rise as high as 2%

–consumer ideas about future inflation are substantially different now than in the 1970s, when large yearly price rises, accelerating into double digits, were commonly expected to occur. In contrast, the NY Fed’s consumer surveys indicate people expect current inflation to gradually shrink to just above 3%

–the 40x rise in the price of oil, a global situation made worse by the US decision to protect an inefficient, gasoline-guzzling auto industry, was a key factor in both inflation and in setting inflation expectations. Today, “peak oil” no longer means the day demand will outstrip supply, however, but the opposite

–a decade of politically expedient too-loose money and the failure of the country to modernize the industrial base after WWII–not to mention Watergate–meant that by the end of the 70s the rest of the world had lost faith in the US. The Treasury was forced to issue bonds in German marks and Swiss francs to attract foreign buyers who feared accelerating inflation and a declining dollar. Today, in contrast, a strong dollar has attracted lots of foreign buyers–meaning they don’t see a parallel between today and the 1970s–and that’s despite the January 6th coup attempt, which makes Watergate look like a schoolyard prank.

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