Volcker taught us ‘tough love’ is difficult

  • Fed legend: Paul Volcker, who tackled inflation by doing the right thing when it was unpopular

    Fed legend: Paul Volcker, who tackled inflation by doing the right thing when it was unpopular


A central bank legend passed away this month at the age of 92. Paul Volcker is well known and remembered as the Federal Reserve chairman who waged war on inflation. His “tough love” stance throughout the 1970s and 1980s broke the inflationary spiral strangling the US economy.

Raising rates to 20 per cent did end inflation but also crushed the stock market and the economy for a time. It was a highly unpopular tactic, but it did finally destroy expectations that prices would continue to rise at a damaging rate. Ironically, one of the world’s most historic fixers of inflation has passed away at a time when the thought of inflation has also died.

In fact, discussing inflation these days seems almost comical. Both The Economist and Bloomberg Businessweek have recently featured covers depicting the end or death of inflation. With an aging demographic, escalating debt levels, and pockets of excess capacity throughout the world, the thought of an inflationary surge seems remote.

The spectre of inflation is pretty much a contrarian opinion. Consumer expectations, central bank opinions, and market forecasts all seem to point to stable or even lower levels of inflation. Therefore, the negative effect a shock would have on investment portfolios is likely to be quite significant.

What could cause inflation to pick up? Good question. It is almost assuredly to assert itself through a combination of things. Maybe economies accelerate from here and employment conditions continue to tighten. As a result, wages, which are rising more than 3 per cent per annum in the US, accelerate further with stretching labour competition.

Maybe oil and gas production, which has been prolific in the US, starts to tail off with rapid depletion in fracking regions in the US, which in turn causes a surge in energy prices. Maybe other commodities whose prices have been crushed in recent years have created some destruction in capital investment. This could lead to large deficits from a supply and demand basis. For example, will the demand for electrification in electric vehicles create a shortage of materials such as lithium, cobalt, and copper?

Maybe the dollar falls and creates an escalation in prices for imports? Or perhaps, the economy begins to show weakness, and governments globally refuse to allow a reset or any deflation to exert itself and instead embark on massive fiscal stimulus coupled with ultra-loose monetary policy?

A broad global trade war could also lead to product shortages and rising production costs which would be passed on to businesses and consumers. There are several possibilities.

If inflation does pick up unexpectedly, yields will likely rise and hurt bond returns. With trillions of dollars of debt still offering an unappealing negative rate of return, the effect could be very pronounced. A rapid rise in interest rates could also negatively affect stocks – higher rates portend to higher discount rates, which make future cash flows less valuable.

High-growth stock with little to no near-term earnings could be walloped, as would “bond proxy” sectors like REITs and utilities, which have arguably benefited immensely from falling rates.

As a result, the traditional 60:40 portfolio of stocks may not perform well unless it holds some real assets or inflation hedges. Inflation risk is so great because it could end up negatively affecting a lot of financial assets at the same time.

Given the risk and the significance it could pose, it may be time to at least consider investments and assets to help offset inflation’s negative ramifications. It would seem prudent to at least have a shopping list ready for those investments that benefit from inflation so that you are prepared if it does assert itself.

Many of these assets are cheap relative to an inflationary outcome as their perceived probability is low to nonexistent.

I think the most crucial thing Volcker taught us is that it is tough to do the right thing when it is unpopular. Maybe it’s time to ponder this further.

Nathan Kowalski CPA, CA, CFA, CIM, FCSI is the chief financial officer of Anchor Investment Management Ltd and can be contacted at nkowalski@anchor.bm

• Disclaimer: The sole responsibility for the content of this article lies with the author. It does not necessarily reflect the opinion, policy, or position of Anchor Investment Management Ltd. The content of this article is not intended to be relied upon as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy or for any other purpose. The information and opinions contained in this material are derived from proprietary and nonproprietary sources deemed by the author to be reliable. They are not necessarily all-inclusive, are not guaranteed as to the accuracy, and are current only at the time written. Past performance is no guarantee of future results. There is no guarantee that any forecasts made will come to pass. Reliance upon information in this material is at the sole discretion of the reader. Investment involves risks. Readers should consult their professional financial advisors prior to any investment decision. The author may own securities discussed in this article. Index performance is shown for illustrative purposes only. You cannot invest directly in an index. The author respects the intellectual property rights of others. Trademark or copyright claims should be directed to the author by e-mail

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Published Dec 16, 2019 at 8:00 am (Updated Dec 15, 2019 at 8:37 pm)

Volcker taught us ‘tough love’ is difficult

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