Asset Allocation Bi-Weekly – The Importance of the Federal Reserve’s Inflation Target (May 28, 2024)

by the Asset Allocation Committee | PDF

Money has three characteristics: medium of exchange, store of value, and unit of account.  When money is taught in undergraduate economics classes, these three functions are treated as self-evident, but careful observation suggests that that the first two characteristics are contradictory.  If a monetary authority emphasizes the medium of exchange function, then it will tend to oversupply specie to the economy.  If the store of value function is favored, then currency is restricted, which tends to support the value of money at the expense of consumption.

In practice, monetary authorities must balance these goals.  However, these authorities don’t exercise policy in a vacuum.  Instead, the dominating factor usually reflects the power structure of a nation.  A society dominated by creditors and asset owners tends to favor the store of value function, whereas one dominated by debtors and consumers favors medium of exchange.  Throughout history, monetary authorities have usually either adopted a gold standard, which tends to favor the store of value function, or a fiat standard, which means the currency’s value is set by the central bank’s control of the money supply.  Throughout history, a fiat standard tends to favor the medium of exchange function.

Price levels should reflect which factor the policymakers favor.  This chart details the CPI index relative to historical monetary regimes.

Our data series begins in 1871.  From the founding of the republic until 1944, the US was on a gold standard for the majority of the time.  During wars, the gold standard was usually suspended, but the government tended to return to it once the conflict ended.  The gold standard did come under pressure during the Great Depression as the dollar was devalued against gold and US private monetary gold holdings were declared illegal.  Despite the erosion, the compound annual growth rate of CPI during this period was 0.54%, clearly low.  The gold standard mostly favors capital owners and creditors; a key reason that political support for the gold standard began to erode in the 1920s was due to expanded suffrage.  Debtors and the unpropertied that fought during WWI demanded a voice in government after the war ended.  What made the gold standard work is that these classes bore the cost of austerity, but once they acquired political power, they were disinclined to accept the austerity demanded by the gold standard.

As WWII was winding down, the allies created a hybrid of the gold standard at Bretton Woods.  Currencies were pegged to the dollar and the dollar was pegged to gold.  As the chart above shows, it was not as effective as the gold standard in containing inflation, but it worked reasonably well.  However, by the early 1970s, a precipitous drain of US gold reserves led President Nixon to suspend gold redemptions in 1971, leading to the “lost years” period on the above chart.  Inflation soared.

To contain inflation and restore confidence in currencies under a fiat standard, Western central bankers gradually established two key rules: central bank independence and a clear inflation target.  Over time, central banks were freed from their finance ministries, which gave them the power to conduct an independent monetary policy.  Since the early 1980s, the central banks of industrialized nations have steadily been granted their independence from fiscal authorities.

The most widely adopted inflation target was 2%; this target was initially established by the Reserve Bank of New Zealand on an offhand comment to a television reporter rather than through careful study.  Other central banks soon adopted the standard.  Although the Federal Reserve didn’t officially adopt the standard until 2012, it was considered the de facto standard as early as 1996.  As the chart above shows, the compound annual growth rate of US CPI over this period exceeded 2%.  The general consensus, though, is that an inflation rate between 2% to 3% is low enough to where economic actors don’t factor inflation into consumption and investment decisions.  And so, the combination of central bank independence and a clear inflation target has mostly been successful in supporting confidence in fiat currencies.  International trade expanded under fiat credibility which suggests that there was general confidence in the dollar as the reserve currency and US Treasurys as the reserve asset.

On the above chart, we have added a fifth regime — The Breakup.  Since the pandemic, the pace of inflation has clearly accelerated.  Although central bank officials argued that the inflation issue was “transitory,” it has instead proven to be persistent.  Central banks have raised interest rates but clearly not to the point where inflation has returned to the Fed’s target level.

There are two factors that we think are undermining the Fiat Credibility regime.  First, there is a sentiment among some notable policymakers that the 2% target is too low.  The fact that in the last decade central banks in some parts of the world lowered their policy rates below 0% and the FOMC engaged in zero interest rates plus balance sheet expansion is prima fascia evidence that the inflation target is too low.  The basic idea is that a higher inflation target would give policymakers greater leeway to stimulate the economy without resorting to unorthodox monetary policy actions.

The second threat may be more formidable.  Across the industrialized world, there are rising pressures on fiscal budgets.  Aging populations are straining government retirement programs, and rising geopolitical tensions are leading to higher defense spending.  In the US, the Congressional Budget Office is projecting high deficits for the rest of the decade.

This chart shows the deficit as a percentage of GDP and the unemployment rate.  We have inserted boxes around periods where the unemployment rate was at or below 4%.  Note that in two periods when the unemployment was at this low level (the late 1960s and late 1990s), deficits tended to be low or, in the case of the latter event, the government ran a surplus.  During the other two events (WWII and after the pandemic), the deficit widened while unemployment was low.  Usually, a strong economy narrows the deficit as tax receipts rise and spending on welfare support programs declines.

What is concerning about the current situation is that despite low unemployment, the Congressional Budget Office is projecting that rather elevated deficits will be continuing.  There is much criticism of this spending in the financial media, with some calling it “the largest deficit in peacetime.”  We quibble with this comment, and we disagree about this being “peacetime.”  In fact, if this is wartime, the deficits will likely be higher in the future.  Defense spending coupled with social spending for retirees will strain budgets.  In general, tax increases are politically difficult.  At the same time, this cold war we are facing is already fracturing global trade, which will tend to increase structural inflation.

In the face of rising deficits, central bank independence is under threat.  These deficits will need to be financed.  To prevent sharp increases in interest rates, central banks may be forced to expand their balance sheets to absorb this debt in order to keep interest rates at manageable levels.  Obviously, something has to give.  We suspect what will “give” will be price levels.  The unknown is how households and firms will react to what is essentially an increase in the inflation target.  If inflation fears rise enough, economic actors will separate the medium of exchange function of money from the store of value function.  If that occurs, some financial and real assets could replace the store of value function for economic actors.  Our task, as asset managers, is to determine which assets will gain that function and invest accordingly.

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Bi-Weekly Geopolitical Report – The Great COVID Labor Reform (May 20, 2024)

by Patrick Fearon-Hernandez, CFA | PDF

The COVID-19 pandemic of 2020 is now starting to fade from memory. Four years after the sudden outbreak of the disease sparked mass economic shutdowns, mask wearing, and millions of deaths, it’s tempting to think the crisis is becoming just another episode of history. However, the pandemic clearly led to changes in the global economy. For example, it helped usher in an era in which governments and companies worry a lot about potential supply chain disruptions.[1]

In this report, we discuss how the pandemic changed the United States labor supply. We focus on two key developments during the pandemic: 1) the mass excess retirements and deaths of baby boomers,[2] and 2) the generous income support programs implemented by the federal government. Considering these developments as a package, we show how they essentially amount to a labor market reform — perhaps the most significant US labor market reform in decades. We then examine how these labor market changes could help spur outsized US economic growth in the coming years, albeit with additional upward pressure on consumer price inflation and interest rates. We wrap up by examining the implications for investors.

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[1] This would not be the first time a pandemic affected the labor markets. The “Black Death” in the 1300s killed so many workers that the lucky survivors saw a jump in real wages. After the Spanish Flu epidemic of 1918, something similar occurred.

[2] The baby boomer generation is conventionally considered to be all those born from 1946 to 1964.

There will be no accompanying podcast for this report.

Asset Allocation Bi-Weekly – The Immigration Paradox (May 13, 2024)

by the Asset Allocation Committee | PDF

Throughout history, immigration has been a politically charged issue, creating a rift between capital and labor. Employers have advocated for looser immigration policies to fill job vacancies, particularly for positions that don’t offer high pay. Conversely, labor unions often push for stricter policies to prevent an influx of workers that could suppress wages. This long-standing divide presents a complex challenge for policymakers seeking a middle ground that satisfies both sides.

The recent surge in immigration has reignited tensions between populists and technocrats. While populists often worry about immigration’s impact on national security, technocrats highlight its potential economic benefits. Research by the nonpartisan Congressional Budget Office estimates that immigrants could contribute $7 trillion to the economy over the next decade. At the same time, there is hope that immigration could help the Federal Reserve achieve its dual mandate of price stability and full employment. According to Fed Chair Powell, the influx of new workers has allowed the country to add new jobs without triggering significant wage pressures.

The argument for allowing increased immigration has gained momentum due to the country’s ongoing shortage of relatively low-skilled workers. Household employment data reveals there has been a decline of 1.1 million workers without a college degree since March 2020. Demographics are also unfavorable. The US fertility rate has hit a record low of 1.62, significantly below the replacement rate of 2.1 children per woman. Falling birth rates have held back the supply of US-born workers. As a result, foreign workers may have accounted for most of the job growth going back to February 2020.

Nevertheless, there is a growing push for stricter immigration policies, even as additional workers are needed for the economy. A Harris Poll survey indicates that more than half of Americans favor tighter controls on illegal immigration. Interestingly, 42% of Democrats — a demographic typically associated with looser immigration restrictions — endorse such measures. This shift in public opinion briefly spurred bipartisan support for the most restrictive immigration bill in recent history. However, the legislation ultimately crumbled as politicians pushed for even stricter measures.

Despite public opposition, rising immigration has demonstrably helped the Fed limit price inflation while keeping employment high. Over the past four years, the influx of foreign workers has helped firms keep a lid on wage rates, thereby reducing cost-push inflation. The hiring of non-natives has also expanded the labor supply without boosting the unemployment rate. For example, the recent surge of foreign workers into the labor force coincided with a fall in the non-seasonally adjusted unemployment rate, from 4.2% in February to 3.9% in March.

Going forward, the rising pushback against immigration may complicate the Fed’s efforts to do its job. Since one of the Fed’s preferred inflation gauges, the Core PCE index for services, is closely linked to wages, a decrease in wage growth is likely necessary in order for the Fed to achieve its inflation target in a reasonable time frame. However, strict measures to limit foreign workers could support wage growth and constrain the Fed’s ability to cut interest rates. A tighter labor market due to fewer foreign workers could put upward pressure on wages, making it harder to control inflation.

Although immigration has helped temper inflation recently, political resistance makes it an unreliable long-term solution for the Fed. Absent significant productivity gains, a more limited labor force could exacerbate inflationary pressures, which could then necessitate restrictive monetary policy to keep price pressures contained. This could lead to a period of underperformance for long-term Treasurys as investors seek higher returns to offset inflation. Of course, the labor market has historically adjusted slowly to immigration changes, so the disinflationary effects of today’s immigration will probably continue for the foreseeable future. Nevertheless, a crackdown on immigration would likely contribute to a less positive environment for bonds in the longer term.

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Bi-Weekly Geopolitical Report – The Changing Face of War (April 22, 2024)

by Daniel Ortwerth, CFA | PDF

If the United States were at war with another great power, would we know it?  How would we know it?  These questions might seem absurd but consider that the US has not fought a war against a major world power since 1945.  Meanwhile, when the US has engaged in conflicts against weaker and regional powers since World War II, the beginnings and endings of the conflicts have tended to be blurred.  Technology has advanced in ways unimaginable to the 1945 mind.  This has changed the nature of life, and it has also changed the face of war.  In this report, we consider how the contours of that face have changed over time, what it takes to recognize war in the 21st century, and whether the US and its allies might already be at war with China and its allies.

By addressing key elements of technological advancement and geopolitical evolution, we explore how 80 years have changed the face of war.  We consider aspects of war that have not and never will change as well as what has changed, and we drive to the bottom line for investors.  In our view, that bottom line has remained constant through time as war is expensive, citizens pay the price, and that price largely manifests itself in the form of higher inflation and long-term interest rates.  Will the US ever go to war again with another major power in a way that we can recognize?  Will we know it when we are there?  These questions are harder to answer than ever before, but investors can still prepare.

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Don’t miss our accompanying podcasts, available on our website and most podcast platforms: Apple | Spotify 

Back to the Future: The Advantages of Dividend Income Over Interest Income (February 2024)

Insights from the Value Equities Investment Committee | PDF

Over the past 15 years, dividend income has often exceeded what could be earned in a money market account. But as seen in the chart below, with the fed funds rate now at 5.5%, the relationship between dividend income and interest income has gone back to what was common before 2008 — where the S&P 500 dividend yield (the blue line) is 2-3% below what could be earned in a money market account invested in U.S. Treasury bills (the red line).

This begs the question:

Why should an income-oriented client still invest in a dividend income-focused stock portfolio yielding 3% when they can now earn 5% in a low-risk money market account?


Higher inflation is causing interest rates to rise on short-term fixed income and money market instruments, and now investors have more choices in generating income returns. While current yields are appealing, we believe it would be short-sighted for long-term investors to abandon the compounding benefits of a growing income stream that can protect purchasing power while also providing for growth of principal.

In this Value Equity Insights report, we highlight some of the potential advantages of growing dividend income through a portfolio of quality, growing businesses — factors which might be underappreciated in the current environment.

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